We reconcile competing theories of the role of phonological memory in reading development, by uncovering their dynamic relationship during the first 5 years of school. Phonological memory, reading and phoneme awareness were assessed in 780 phonics-educated children at age 4, 5, 6 and 9. Confirmatory factor analyses demonstrated that phonological memory loaded onto two factors: verbal short-term memory (verbal STM; phonological tasks that loaded primarily on serial order memory) and nonword repetition. Using longitudinal structural equation models, we found that verbal STM directly predicted early word-level reading from age 4 to 6, reflecting the importance of serial-order memory for letter-by-letter decoding. In contrast, reading had no reciprocal influence on the development of verbal STM. The relationship between nonword repetition and reading was bidirectional across the 5 years of study: nonword repetition and reading predicted each other both directly and indirectly (via phoneme awareness). Indirect effects from nonword repetition (and verbal STM) to reading support the view that phonological memory stimulates phonemically detailed representations through repeated encoding of complex verbal stimuli. Similarly, the indirect influence of reading on nonword repetition suggests that improved reading ability promotes the phoneme-level specificity of phonological representations. Finally, the direct influence from reading to nonword repetition suggests that better readers use orthographic cues to help them remember and repeat new words accurately. A video abstract of this article can be viewed at https://www.youtube.com/watch?v=70LZfTR0BjE.