Inside Money and Outside Money
Inside money and outside money are two important concepts in monetary economics used to classify money based on its origin and backing.
Inside money refers to money that is created within the private sector, typically through the banking system. It is a liability for one private agent and an asset for another. The most common example is bank deposits created when commercial banks extend loans. When a bank gives a loan, it credits the borrower’s account, thereby creating deposit money. This deposit is an asset for the depositor but a liability for the bank. Since inside money is backed by private credit relationships, its net value to society is essentially zero—one person’s asset is another’s liability.
Outside money, on the other hand, is money that is not a liability of any private individual or institution within the economy. It is typically issued by the central bank or the government and forms an asset to the private sector without a corresponding private liability. Examples include currency notes and coins issued by the central bank and monetary base created by the government. Outside money is considered “net wealth” for the private sector because it is not offset by private debt.
High-Powered Money (Reserve Money) and Its Role in the Money Multiplier Process
High-powered money, also called reserve money or monetary base, consists of currency in circulation (held by the public) plus reserves held by commercial banks with the central bank. It is called “high-powered” because it serves as the foundation on which the banking system creates a much larger supply of money through deposit creation.
The components are:
- Currency with the public
- Cash reserves of commercial banks
- Deposits of commercial banks with the central bank
High-powered money plays a crucial role in the money multiplier process, which explains how an initial increase in the monetary base leads to a larger increase in total money supply.
When the central bank injects high-powered money (for example, by purchasing government securities), it increases bank reserves. Commercial banks then use these reserves to extend loans. When loans are given, new deposits are created in the banking system. A portion of these deposits is kept as required reserves (based on the reserve requirement ratio), while the remaining portion is lent out again. This repeated process of deposit creation and lending expands the money supply multiple times the original increase in high-powered money.
Money Multiplier and Its Influence on Total Money Supply
The money multiplier measures how much the money supply expands due to an increase in the monetary base. It is defined as:
In a simplified model, the money multiplier can also be expressed as:
where rr is the required reserve ratio. In reality, the multiplier is affected not only by reserve requirements but also by public preference for holding cash and banks’ willingness to lend.
The total money supply in the economy is influenced by the multiplier as follows:
This means that any change in the monetary base will have a multiplied effect on the overall money supply. For example, if the central bank increases high-powered money, the banking system can create multiple rounds of deposits and loans, significantly expanding the money supply. Conversely, if the public holds more cash or banks increase excess reserves, the multiplier falls, reducing the expansion of money supply even if the monetary base remains unchanged.
Conclusion
Inside money is created within the banking system as credit, while outside money is created by the central bank and represents net financial wealth. High-powered money forms the foundation of the banking system and drives money creation through the multiplier process. The money multiplier determines how strongly changes in the monetary base translate into changes in total money supply, making it a key concept in monetary policy and macroeconomic stability.
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