Inside money

3 key takeaways

• Inside money is created within the private sector, primarily by banks, and includes bank deposits and other financial instruments.
• It functions as a medium of exchange, store of value, and unit of account within the economy, facilitating transactions and economic activity.
• The creation and regulation of inside money are crucial for monetary policy, financial stability, and economic growth.

What is inside money?

Inside money is a form of money that is generated by financial institutions through their lending and deposit-taking activities. When banks issue loans, they create new deposits in the banking system, which constitutes inside money. This money is backed by the financial assets and liabilities within the banking system, rather than being directly issued by a central authority.

How inside money works

Creation of Inside Money: Inside money is created when banks extend loans to borrowers. The loan amount is credited to the borrower’s account as a deposit, increasing the total money supply within the economy.

Bank Deposits: The most common form of inside money is bank deposits. When individuals or businesses deposit money in a bank, they receive a claim on the bank for that amount, which can be used for transactions or withdrawn as cash.

Balance Sheet Dynamics: On a bank’s balance sheet, deposits (inside money) appear as liabilities, while loans and other financial assets appear as assets. The bank must manage these assets and liabilities to maintain liquidity and solvency.

Role in the Economy: Inside money plays a crucial role in facilitating transactions, credit creation, and overall economic activity. It allows for the efficient allocation of resources and supports economic growth by providing the necessary liquidity for businesses and consumers.

Importance of inside money

Monetary Policy: Central banks monitor and regulate the creation of inside money as part of their monetary policy operations. By influencing interest rates and reserve requirements, central banks can control the money supply and stabilize the economy.

Financial Stability: The stability of the banking system is essential for the effective functioning of inside money. Banks must maintain adequate capital and liquidity to ensure they can meet withdrawal demands and manage financial risks.

Economic Growth: Inside money supports economic growth by providing the necessary funding for investment, consumption, and business expansion. Access to credit and liquidity enables businesses to invest in new projects and consumers to make purchases.

Intermediation: Banks act as intermediaries by transforming short-term deposits into long-term loans, facilitating investment and consumption in the economy. This intermediation process is vital for economic development and financial market efficiency.

Example of inside money in action

Example: Bank Loan and Deposit Creation

A business takes out a loan of $100,000 from a bank to expand its operations. The bank credits the business’s account with $100,000, creating a new deposit.

• Loan Creation: The bank issues a loan of $100,000 to the business.
• Deposit Creation: The loan amount is credited to the business’s bank account as a deposit.
• Balance Sheet Impact: The bank’s assets increase by $100,000 (loan) and its liabilities increase by $100,000 (deposit).

This example illustrates how inside money is created through the lending activities of banks, increasing the money supply within the economy.

Challenges and considerations

Regulatory Oversight: Effective regulation and supervision of banks are necessary to ensure the stability and integrity of the banking system, preventing excessive risk-taking and financial crises.

Liquidity Management: Banks must manage their liquidity carefully to meet withdrawal demands and maintain confidence among depositors and investors.

Credit Risk: The creation of inside money involves credit risk, as borrowers may default on their loans. Banks must assess and manage this risk to maintain their solvency.

Economic Cycles: The supply of inside money can fluctuate with economic cycles, affecting credit availability and economic stability. Central banks use monetary policy tools to mitigate these effects and support sustainable growth.

Related topics

• Outside money
• Monetary policy
• Banking system
• Financial intermediation

Explore these related topics to gain a deeper understanding of the different forms of money in the economy, the role of financial institutions in money creation, and the impact of monetary policy on economic activity and financial stability.