Federal Reserve Bank of Minneapolis

Research Department Staff Report 374

May 2006

Inside and Outside Money

Ricardo Lagos
Federal Reserve Bank of Minneapolis
and New York University

ABSTRACT __________________________________________________________________________

A distinction is drawn between outside money—money that is either of a fiat nature or backed by some
asset that is not in zero net supply within the private sector—and inside money, which is an asset backed
by any form of private credit that circulates as a medium of exchange.
_____________________________________________________________________________________

*This paper has been prepared for the New Palgrave Dictionary of Economics, 2nd edition. I thank Narayana Kocherlakota and
Warren Weber for comments. I also thank the C.V. Starr Center for Applied Economics at New York University for financial
support. The views expressed herein are those of the author and not necessarily those of the Federal Reserve Bank of
Minneapolis or the Federal Reserve System.
Inside and Outside Money

Definitions

Money is an asset that serves as a medium of exchange.

Outside money is money that is either of a fiat nature (unbacked) or backed by some asset that is

not in zero net supply within the private sector of the economy. Thus, outside money is a net asset

for the private sector. The qualifier outside is short for (coming from) outside the private sector.

Inside money is an asset representing, or backed by, any form of private credit that circulates as a

medium of exchange. Since it is one private agent’s liability and at the same time some other

agent’s asset, inside money is in zero net supply within the private sector. The qualifier inside is

short for (backed by debt from) inside the private sector.

Background

In 1960, John G. Gurley and Edward S. Shaw published Money in a Theory of Finance. In this

book, they attempted to develop a theory of finance that encompasses the theory of money and a

theory of financial institutions that includes banking theory.

Consider a simple economy similar to the one considered by Gurley and Shaw. The economy has

fiat money—an intrinsically useless asset with no backing whatsoever—that is generally accepted

as a means of payment. A monetary authority or “government” has the monopoly to issue this

asset. The economy is closed and consists of three sectors: households, firms, and government.

Firms issue debt in the form of homogeneous, perfectly safe nominal bonds. (For example, think

of these bonds as being promises to pay $1 at some future date.)

 Table 1

Households Firms Government

Assets Liabilities Assets Liabilities Assets Liabilities
Money 50 Money 100 Bonds 25 Money 150
Bonds 25 Capital 200 Equity 275
Equity 275
NW 350 NW 0 NW -150

Table 1 shows hypothetical sectoral balance sheets for this economy. In this example, households

hold only financial wealth (i.e., no real wealth such as houses), in particular money, equity on the

firms, and the bonds issued by the firms. Here households have no liabilities, so their net worth

(NW) is just the sum of the value of their assets. The assets owned by firms consist of cash and

physical capital. A part of these assets has been financed with debt (bonds) and another part by

issuing equity. The former represent the firms’ liabilities toward the bond holders, and the latter

represent the firms’ liabilities toward shareholders. The firm’s net worth (net of equity) is zero.

The government has no real assets, but at some point in the past, it issued financial assets—

money—to pay for expenditures, and from an accounting point of view, these outstanding

government-issued pieces of paper constitute liabilities.1

Table 2 shows what happens if we consolidate the balance sheets of the private sector. The bonds

are debts from private agents (in this example, the firms) to other private agents (in this example,

the households), so they have canceled out. The only assets left in the balance sheets of the public

sector are physical capital and the money issued by the government. Money can be thought of as

a “claim” held by consumers and firms against the government. From the standpoint of the

private sector, it is a net external, or outside, claim: it is outside money.

1
If the money was backed by a real asset, e.g., gold, and also fully convertible, then the value of the gold would show
up on the government’s Assets column. In this case, the money issued is literally a liability representing the
government’s commitment to redeem the money for gold. In the case of fiat money, there need not be a counterpart on
the Assets column of the government’s balance sheet.
 Table 2

Combined Private Sector Government

Assets Liabilities Assets Liabilities
Money 150 Money 150
Capital 200
NW 350 NW -150

Gurley and Shaw were interested in considering the effects of “open market operations” whereby

the government issues money to purchase private bonds. Suppose, for example, that they

purchase $15 worth of private bonds. The resulting balance sheets are those in Table 3, which

should be compared with those in Table 1. The government now has $15 worth of assets (the

private bonds it purchased), and its liabilities have increased by $15 because of the money issued

to pay for these bonds. Households still hold $350 worth of assets, but the composition of their

portfolio has changed: they now hold $65 in money and $10 in bonds, as opposed to the $50 in

money and $25 in bonds of Table 1. The additional $15 in money holdings comes from the new

issue of money, backed by private bonds. These $15 are government debt, but they are issued in

payment for government purchases of private securities. They are a claim of consumers and firms

against the world outside the private sector, but they are counterbalanced by private debt to the

world outside, i.e., to the government. These additional cash balances are based on internal debt,

so Gurley and Shaw referred to these $15 as inside money.

Using the terminology of Gurley and Shaw, the $165 stock of money in the economy of Table 3

consists of $150 of outside money and $15 of inside money. Both types of money are really the

same physical object, e.g., green pieces of paper: The qualifiers inside and outside refer to the

asset counterpart of the money. Inside money is backed by private domestic debt. Outside money

is of a fiat nature (or backed by some other asset that is not in zero net supply within the private
sector, e.g., gold). Note that if we consolidate the balance sheets of the private sector in Table 3,

the net worth of the private sector is still $350, just as in Table 2. Also, note that inside money is

“endogenous” in that if, for example, firms pay off their whole debt, ceteris paribus, the money

supply would shrink by $15. Most likely, Gurley and Shaw were led to stress the distinction

between inside and outside money because they viewed money and private debt as assets that

played distinct roles in exchange, so that an economy with the balance sheets of Table 1, where

households hold $50 in cash and $25 in private bonds, would function differently from an

economy with the balance sheets of Table 3, where households hold $65 in cash and $10 in

private bonds.2

Table 3

Households Firms Government

Assets Liabilities Assets Liabilities Assets Liabilities
Money 65 Money 100 Bonds 25 Bonds 15 Money 165
Bonds 10 Capital 200 Equity 275
Equity 275
NW 350 NW 0 NW -150

The contemporary literature on monetary theory in general, and the subfield that deals with inside

and outside money in particular, does not take as given that money and bonds play different roles.

Instead, it seeks to understand whether they indeed do, and whether they ought to. The recent

emphasis has been on trying to gain a deeper understanding of the precise roles that fiat money

2
Refer to the section “Monetary Policy in a Modified Second Model,” pp. 82–88. The theoretical analysis throughout
the book is predominantly verbal, so it is not clear which are the precise trade-offs that agents consider when making a
portfolio decision between money and bonds. The fact that households treat them as different assets is explicit in the
Mathematical Appendix, where Alain C. Enthoven assumes distinct reduced-form demand functions for the two
financial assets. Note that since bonds are nominal and risk less in this setup, it is not obvious why households would
not treat them as perfect substitutes for money.
and private debt play and ought to play, both as media of exchange and as vehicles to channel

resources across economic agents, toward their most efficient use.3

Contemporary Perspectives

Gurley and Shaw simply asserted that agents would want to hold government-issued fiat money

(this weakness was stressed by Patinkin, 1961), and for their purposes, the distinction between

inside and outside money was relevant because they implicitly regarded them as imperfect

substitutes. The modern literature on monetary theory seeks to identify the fundamental features

of the basic economic environment that can make fiat money, or more generally, any asset that

serves as a medium of exchange, valuable and socially beneficial. Modern theory also focuses on

the differences and similarities between inside and outside money. When is outside money

valued? Under which circumstances does inside money arise? Are inside and outside money

substitutes or complements? Under which circumstances can they coexist? Are they both needed

to achieve efficient outcomes?

Inside money is private debt that also circulates as a tangible medium of exchange. Thus, an

economy with inside money must perform a delicate balancing act: On the one hand, it must have

enough commitment or enforcement for credit to be feasible, but at the same time, credit must not

function too well, for otherwise a tangible medium of exchange would be inessential. For

example, Kocherlakota (1998) shows that a tangible medium of exchange is not essential if

agents can commit to future actions or if their trading histories are public. Starting from this

observation, Cavalcanti and Wallace (1999a) consider an environment where trading histories are

3
This change of emphasis has led to a slightly different definition of inside money. The more modern use of the
concept does not rely on the type of open market operations of Gurley and Shaw. Inside money need not be defined
narrowly as circulating fiat money backed by private debt: The private debt itself is regarded as inside money if it
circulates as means of payment among the private agents. (The more modern definition given at the beginning of this
article encompasses both the case in which private debt circulates directly, as well as Gurley and Shaw’s original
example.) To illustrate, consider again the economy of Table 1. There is not enough information in that table to decide
how much inside money there is in the economy: there are $25 worth of inside assets, i.e., assets that are in zero net
supply within the private sector, but whether these assets constitute inside money depends on whether they circulate as
means of payment. If they do not—for example, if lenders merely hold the bonds until maturity to redeem them—then
these bonds are not inside money.
public for a subset of agents but private for the rest, and show that a social optimum requires note

issue by those agents with public trading histories. In addition, those notes are in turn used in

trade among the agents whose trading histories are private. Thus, in their environment, an

optimum requires inside money.

Kiyotaki and Moore (2002) instead consider an environment where everyone is anonymous, and

emphasize the importance of the agents’ ability to make bilateral and multilateral commitments.

The degree of (bilateral) commitment a borrower can make to an initial lender when selling a

paper claim places a bound on the entire stock of private debt. The degree of (multilateral)

commitment a borrower can make to repay any bearer determines the extent to which the

borrower’s debt can circulate in equilibrium. Kiyotaki and Moore find that only outside money

circulates in economies with very low degrees of bilateral commitment. For higher but still low

degrees of bilateral commitment, outside and inside money circulate alongside in equilibrium. For

yet higher degrees, only inside money circulates, and when the agents’ ability to make bilateral

commitments is large enough, the economy can manage without any money, inside or outside.
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