Inside Money

In monetary economics, inside money is money created by banks—principally deposits—that represents a simultaneous asset and liability within the private sector. When a bank extends credit, it creates a deposit (money) owed to the borrower; this is inside money. It contrasts with outside money: central-bank currency or other stores of value that exist independently of the banking system’s balance sheet.

How inside money differs from outside money

Imagine a closed economy with only a central bank, private banks, and households. The central bank issues £1 million in notes—outside money, not owed to anyone, simply circulating as currency. This is true base money: it exists whether banks operate or not.

Now a commercial bank loans £100,000 to a firm. The bank credits the firm’s deposit account with £100,000. This is inside money. The firm now has an asset (a deposit it can spend), and the bank has a liability (money it owes the firm on demand). These two sides of the ledger net to zero: the firm’s asset is the bank’s obligation. Inside money does not add to the total wealth of the private sector; it redistributes claims within it.

When the firm repays the loan, the deposit is cancelled. The inside money disappears. Outside money—the central-bank notes still circulating—remains.

Why inside money matters

Inside money is not merely an accounting curiosity. In modern economies, inside money vastly outnumbers outside money. Most economic transactions settle via bank transfers—the movement of deposits from one account to another. Few transactions use physical notes or central-bank currency.

Because inside money is so prevalent, banks wield enormous economic power. They decide, through lending decisions, how much inside money is created. They control the liquidity available to firms and households. A bank that refuses to lend constrains real economic activity, even if the central bank supplies abundant outside money (notes and central-bank reserves).

This distinction is crucial to endogenous money theory. If most money is inside money created by banks, then the central bank cannot directly control the money supply by printing notes. The central bank can influence the creation of inside money through interest rates and reserve requirements, but it cannot dictate how much banks lend.

The circuit of production: inside money at work

Post-Keynesian economists frame the economy as a “circuit” of production in which inside money plays the starring role.

Firms borrow from banks to finance production: wages, raw materials, equipment. The bank creates deposits (inside money) credited to the firm’s account—but these deposits are liabilities of the bank, claims that must eventually be backed by outside money or by new inside-money creation elsewhere. The firm spends the deposits: workers receive wages (deposits transferred to their accounts), suppliers receive payment. Throughout, inside money circulates. Eventually, the firm sells its product, receives revenue, and repays the loan. The inside money is destroyed; the circuit completes.

In this view, inside money is not a store of value (like outside money or gold) but a financing tool—a temporary obligation that finances activity and then disappears. The level of inside money in circulation reflects the pace of production and the confidence of banks in lending.

Net worth and aggregate demand

A subtle but important point: inside money, in aggregate, has zero net worth to the economy. If all banks’ deposits (liabilities) are added up, and all loans (assets) are subtracted, the net is zero—every deposit is someone’s claim on someone else. By contrast, outside money is net wealth; if the central bank issues £1 billion in notes, that is £1 billion of real purchasing power created.

This is why, in the equation of exchange and quantity-theory discussions, the growth of inside money does not automatically inflate prices the way outside-money growth (central-bank printing) might. Inside money expands and contracts based on credit demand and real economic activity. If firms and households are optimistic and borrowing heavily, inside money surges. If they are pessimistic and deleveraging, inside money contracts—even if the central bank supplies abundant outside money.

Central bank reserves as inside money to banks

Technically, central-bank reserves held by commercial banks are also inside money from the central bank’s perspective: liabilities of the central bank owed to banks. But economists often treat reserves differently because banks cannot spend reserves directly—they clear payments through reserve transfers. And central banks can create reserves almost without constraint (they print the currency), whereas commercial banks face limits (capital requirements, deposit insurance, creditworthiness).

The hierarchy of money

Modern economies have a hierarchy:

1. Commodity/outside money (rare today): gold, a scarce commodity with intrinsic value.
2. Central-bank outside money: fiat currency issued by the central bank; notes and reserves. Highest-quality money; risk-free to the holder (though subject to inflation).
3. Inside money from large banks: deposits at major, well-capitalised banks; nearly as liquid and safe as outside money.
4. Inside money from smaller banks or near-banks: less liquid or less certain of repayment; carries counterparty risk.
5. Inside money from non-financial firms: trade credit, commercial paper; lower in the hierarchy.

Most economic agents treat grade 1–3 as “money.” Grades 4–5 are money-like but less certain. During financial crises, the hierarchy matters sharply: a run on banks erodes faith in grades 3–4, forcing agents to hoard grade 2 (outside money), shrinking the money supply and crunching credit.

The 2008 crisis and inside money

The 2008 financial crisis illustrated inside money’s fragility. U.S. banks had created vast quantities of inside money in the form of mortgages and structured credit. When house prices fell and mortgage defaults rose, the value of banks’ assets (mortgage-backed securities) collapsed. Depositors and creditors lost faith in banks’ ability to repay. Runs occurred: people withdrew outside money, forcing banks to sell assets at fire-sale prices. Inside money contracted catastrophically as banks failed, loans were written off, and deposits were frozen or lost.

The central bank intervened by flooding the system with outside money (quantitative easing) to stabilize banks and reassure depositors. But the expansion of outside money did not immediately restore inside money; banks remained reluctant to lend, and borrowers were unwilling to borrow. Inside money continued shrinking for years even as outside money exploded. Only gradually, as confidence returned, did inside-money creation resume.

Inside money and monetary policy

Central banks use inside money creation as a lever. By setting interest rates, they influence the attractiveness of lending: lower rates encourage banks to lend (more inside money created), higher rates discourage it. By adjusting reserve requirements, they change the leverage at which banks can operate. By purchasing assets in open-market operations, they inject outside money, which banks can relend, multiplying it into inside money.

But the transmission is indirect and uncertain. A central bank cannot force banks to lend or borrowers to borrow. If confidence collapses, low rates and abundant outside money do not translate into inside-money creation. Japan’s “lost decades” and the 2020 pandemic stimulus—massive injections of outside money with muted effect on inside-money growth and inflation—both illustrate the limits of central-bank tools when credit demand is weak.

See also