1) Concepts of Inside Money and Outside Money
Inside money refers to money that is created within the private sector, particularly by commercial banks. It is called "inside" because its issuance creates a corresponding liability within the financial system. The most common example is bank deposits. When a bank gives out a loan, it credits the borrower's account, effectively creating new money. However, this money is also a liability for the bank, as it owes that amount to the depositor. Hence, inside money is an asset for the public and a liability for banks.
Outside money, on the other hand, is money that exists outside the private banking system and is not backed by a corresponding liability within the system. It is usually issued by the government or central bank. Examples include fiat currency (physical cash) and central bank reserves. Since outside money is not created through lending, it does not have an offsetting liability within the private financial sector.
2) Role of High-Powered Money in the Money Multiplier Process
High-powered money, also known as the monetary base, consists of currency in circulation (held by the public) and reserves held by commercial banks at the central bank. It is considered "high-powered" because it forms the foundation for the broader money supply through the money multiplier process.
The central bank directly controls the supply of high-powered money. Commercial banks use a portion of these reserves to make loans, while maintaining a fraction to meet reserve requirements. This lending creates new deposits, thereby expanding the money supply.
The money multiplier process begins when the central bank injects reserves into the banking system—either through open market operations, lending to banks, or other mechanisms. Banks then lend out a portion of these reserves, leading to deposit creation in another bank. That bank can then lend a portion again, and the process continues.
For example, suppose the reserve requirement is 10%. If the central bank injects $1,000 in reserves, banks can, in theory, create up to $10,000 in new money through repeated lending and deposit creation. This chain reaction is the essence of the money multiplier.
The size of the multiplier depends on several factors, including:
- Reserve requirements: Higher reserve ratios reduce the money multiplier.
- Currency-deposit ratio: If the public prefers to hold more cash instead of deposits, the multiplier effect is weaker.
- Bank willingness to lend and borrower demand for loans.
3) Impact of the Money Multiplier on the Overall Money Supply
The money supply in an economy (commonly measured as M1 or M2) is determined by both the monetary base and the money multiplier. The relationship can be expressed as:
Money Supply = Money Multiplier × Monetary Base
This means that any change in the monetary base or the multiplier will affect the total money supply.
- If the central bank increases the monetary base by injecting reserves (through buying government securities, for instance), the potential for deposit creation expands, increasing the money supply—assuming the multiplier remains constant.
- If banks become more willing to lend and the public is willing to hold more deposits (e.g., during times of economic optimism), the money multiplier increases, thus amplifying the effect of a given monetary base.
Conversely, during times of economic uncertainty or financial crisis:
- Banks may hold excess reserves instead of lending,
- The public may withdraw cash rather than keeping deposits,
- Borrowers may be unwilling or unable to take loans.
All these factors reduce the money multiplier, limiting the effectiveness of monetary base expansions.
Therefore, while the central bank has control over the monetary base, the overall money supply is influenced by the behavior of banks and the public, which affect the money multiplier. This is crucial for monetary policy, as central banks rely on manipulating the base to influence economic variables like inflation, interest rates, and growth.
Conclusion
In summary, inside money is created by the private banking system through lending, while outside money is created by the central bank. High-powered money acts as the base for the creation of inside money via the money multiplier process. This multiplier amplifies the initial injection of reserves into a larger money supply, although its effectiveness depends on several real-world factors. Understanding this process is vital for analyzing how monetary policy influences the economy.
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