Outside Money

Published Apr 29, 2024

Definition of Outside Money

Outside money refers to assets that serve as a form of currency outside the banking system and are considered an external source of net wealth to the economy. Primarily, it includes forms of money not created within the private sector, such as physical currency (coins and banknotes) issued by the central bank and any reserves held by banks at the central bank. Typically, outside money is contrasted with inside money, which is the wealth created within the private sector, such as deposits in commercial banks.

Example

Imagine the central bank of a country decides to introduce more money into the economy by printing new currency notes. This injection of cash increases the total amount of outside money available to the public and the banking system. Suppose, initially, the total amount of outside money in circulation was worth $500 billion. After the central bank prints an additional $50 billion and distributes it, the new total of outside money in circulation rises to $550 billion.

For individuals and businesses, this newly printed currency can be used for transactions, savings, or as reserves by banks. The increase in outside money directly raises the net wealth of the economy from an external source, as it does not correspond to any individual or business’s debt within the economy.

Why Outside Money Matters

Outside money plays a pivotal role in the monetary system and the broader economy for several reasons. It constitutes the base of the money supply, upon which banks can create inside money through lending activities. The amount of outside money in circulation can influence inflation rates, interest rates, and overall economic growth. Central banks manage the supply of outside money to implement monetary policy, aiming to steer the economy towards specific targets like stable prices, low unemployment, and sustainable growth.

By adjusting the amount of outside money, central banks can influence economic conditions. For instance, increasing the supply of outside money can stimulate economic activity in times of recession, while decreasing it can help cool down an overheated economy. This management of outside money supply is a crucial tool for central banks in their efforts to maintain financial stability and economic health.

Frequently Asked Questions (FAQ)

How does outside money compare to inside money?

Outside money and inside money are both components of the money supply, but they originate from different sources. Outside money, issued by the central bank or government, represents a liability on the central bank’s balance sheet but is an asset to the private sector, adding to its net wealth. Inside money, in contrast, is created within the private banking system through lending processes and is backed by private credit. While outside money forms the base monetary assets of an economy, inside money consists mostly of the debts of individuals and institutions.

What impact does an increase in outside money have on inflation?

An increase in outside money can lead to inflation if the additional money leads to higher spending and demand that outpaces the economy’s ability to produce goods and services. Essentially, too much money chasing too few goods and services can push prices upward, resulting in inflation. However, the impact on inflation also depends on other factors such as the current economic conditions, the pace of economic growth, and the existing levels of production capacity.

Can outside money be negative?

The concept of outside money being negative is not conventional, as outside money is typically considered an asset to the private sector. However, in a theoretical sense, if the liabilities associated with holding currency (for instance, the erosion of value due to inflation or costs related to storing and securing large amounts of cash) exceed the assets’ value, the net benefit of holding outside money might be perceived negatively. Nonetheless, in practical terms, outside money is a positive asset representing net wealth in the economy outside the banking system.

Outside money’s role in the economy highlights the intricate balance between monetary policy, economic growth, and inflation. Its management by central banks is crucial for steering the economy towards desired outcomes, demonstrating the interconnectedness of government actions, the banking sector, monetary supply, and overall economic health.