1. Free supply money and growth

Free supply money and growth: I

I. M3 free supply money

The variation of the real GDP growth rate is inversely proportional to that of the free money supply which is the difference between the increase of the money supply M3 in current data and (less) the growth rate of the real GDP.

In fact the variations of this free money supply are important: as it increases, the real GDP growth decreases, and conversely.

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The free money supply is a concept derived from the free cash-flow which is the total cash-flow less the part which will be in any case used to finance the renewal of the fixed assets (to maintain in state the outputs), the payment of the income taxes and of the dividends.

This free cash-flow is important for a company: it varies a lot according to the economic situation and to the (good or wrong) decisions of its managers. M3-M2 represents the whole of the treasuries of the companies and M2-M1 the saving of the households.

The variations of these aggregates are thus found in those of the free money supply M3.

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Thus, in a normal situation, the real GDP growth is 3.5 percent and that of the free money supply is also 3.5 percent (the increase in M3 is then higher than 7 percent in current prices). As the variation of the free money supply accelerates (by exceeding 3.5 percent more and more), the real GDP growth slows down more and more under its optimal potential of 3.5 percent and conversely: as the variation of the free money supply decreases (while passing more and more under 3.5 percent), the real GDP growth increases more and more, over its optimal potential of 3.5 percent.

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Figure 1 : http://s3.archive-host.com/membres/up/2107676425/200702051M3.gif

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To start again the GDP growth (when it is lower than its optimal potential), it is thus necessary to decrease more and more the free money supply and for this reason it is necessary that the households save relatively less (by spending and investing more, what starts again the demand), and that the increase in the cash-flows is weak (the companies must distribute more dividends and especially increase their investments, what starts again the supply).

Conversely, to decrease a growth of a real GDP too strong, higher than its optimal potential (thus inflationary and insupportable in the long term), it is necessary to increase more and more the free money supply by an increase in the saving of the households (on savings accounts in M2-M1, the households feeling to come the slowdown then constitute an increasingly important precautionary saving by consuming relatively less and investing less, what decreases the demand), and an increase in the cash-flows of the companies (in M3-M2 by distributing less dividends and investing less, what decreases the supply).

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The central banks must make move the markets in the wanted direction, by increasing or decreasing the basic rate according to circumstances, to vary the free money supply so that the real GDP growth is nearest possible to its optimal potential without inflation.

The ideal would be that the growth of the real GDP is stable to 3.5 percent, without variations, but such a situation of balance is never durable. However, the Fed succeeds in with the passing of years decreasing the range of the real GDP growth and of the free money supply which were sometimes important: it increased of more than 10 percent in 2001 and it decreased at the end of 2003 beginning 2004, which corresponded to a recovery very (too much) strong of the real GDP thereafter because inflation set out again.

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On the long term, the increase in the free supply money is higher than the real GDP growth of a half point at least, which is due to an wealth’s effect of the households and companies. Indeed, when the growth of the real GDP increase, the households and the companies are richer and thus save more.

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Contrary to the commonly widespread ideas, it is thus not by increasing the free money supply that a central bank can start again the economic activity, but on the contrary by restricting it (by decreasing its basic rate) provided that there no were before monetary skids (as in Japan for example).

Conversely it slows down the GDP growth by increasing the free money supply (by increasing its basic rates).

What imports is thus the evolution of the free money supply (in rise or fall), growth of the real GDP being inversely proportional.

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The Fed does not publish any more since March 13, 2006 the data of M3, which prevents from well analyzing these problems.

However, this measurement does not present major disadvantages because the law of the free money supply functions with M2-M1 and the evolution of the cash-flows of the companies can be known by other reliable means.

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I studied these monetary problems in collaboration with Fred Rabeman, technical analyst, whom I thank: http://www.maestrade.com/

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February 6, 2007 (according to an article written in French published on June 25, 2006 and an other paper in English on January 10).

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