Money

Inside Money, Outside Money

The distinction between ‘Inside Money’ and ‘Outside Money’ was introduced in macro economics by Gurley, and Shaw in their work ‘Money in a theory of Finance’. They made this distinction in order to show that neutrality of money can be ensured with only ‘inside money’ or only with ‘outside money’ but not when both types of money exist in an economy.

Inside money refers to the financial claims of economics units in the private actor of the economy. Outside money is government money. It consists of the liabilities of the government as a debtor. It is, therefore, a claim of the private sector as creditors.If there is only ‘inside money’, any increase in the net wealth of the creditors would be counterbalanced by a corresponding reduction in the net wealth of the debtors. So there would be no change in the net wealth of the community in this case and so money would remain neutral.


If there is only ‘outside money’, an increase of this type of money causes a corresponding increase in the net wealth of the economy of the private sector. This causes rise in the price level, leaving the relative prices unchanged. In this case money is neutral.

The third case is where ”inside money’ and ‘outside money’ both co-exist. Here a change in the stock of money disturbs the neutrality of money because it will cause change in relative prices due to income redistribution between the public sector and the private sector. Additional money supply by the government will change the relative prices of the assets in the private sector through its effect on the rate of interest. Extra money in the private sector invariably affects the portfolios of investors and hence its is non-neutral.

It should be noted that lately the distinction between ‘inside money’ and ‘outside money’ stands blurred because of the increase in the width and the depth of the capital market and deregulation of non-banking financial institutions.

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Definition of Money

There is no unanimity among economist over the definition of money. The main reason for this is that the definition of money cannot be a static one in this dynamic society.

The present day money is quite different from what it was two or three hundred years ago.There was a time when money was only gold and silver coins. But with the advancement of society, paper, notes, deposits of commercial banks which are transferable by cheque have also come to be regarded as money. The main issue in the controversy over the definition of money whether time deposits (deposits not transferable by cheque) and deposits of saving banks and other non-banking financial institutions should be include in the stock of money or not. This is still an unsettled question.

There are two approaches to the specification of what constitutes money functional and empirical. In the functional approach, the theoretical properties of assets called money are specified and the assets having these properties are include in the money stock. In the empirical approach, an examination of various financial assets is done with a view to finding out the assets which satisfy the given criteria. Some of the criteria are : stability of demand function of money, degree of sustainability between various assets and correlation of various assets with the real variables of economy such as income etc. The functional approach is the traditional approach. The empirical approach is meant for planning and policy purposes.

Functional Definition: Traditionally, money is defined in terms of its functions. In these definitions various characteristics of money such as spendability, liquidity are specified.
One such definition is of George Ranlett.

According to George Ranlett

“Money is anything that is spendable and is defined as the unit of account.”
In this definition the ‘spendability of money is emphasized. Spendability of money implies that it generally acceptable as a means of payment.

According to Solomon and Shapiro
“Money is anything that is both a medium of exchange and is defined as the unit of account.”

They have observed, “Money, therefore, may be defined as anything which has fixed and unvarying price in terms of unit of account and is generally accepted within a given society in payment of debt or for goods and services rendered.”

Modern quantity theorists like Milton Friedman emphasize another aspect of money.

According to Milton Friedman

Money is a ‘temporary abode of purchasing power’. With the introduction of money, a single transaction of barter is split up into two transactions i.e sale and purchase. The time separation of the acts of sale and purchase demands that the payments media used be also capable of serving as temporary store of purchasing power.

If we consider this property as an essential characteristics of money, then all forms of wealth as stores of value can be included in the stock of money. Quantity theorists emphasize this aspect of the demand for money when they insist on the inclusion of the characteristics of spendability, and that time deposits cannot be include in the money supply since time deposits are not spendable . But if money is defined in such broad terms as anything which acts as temporary abode of purchasing power, we cannot precisely know the constituents of money supply. According to Prof. James Tobin, ” such open minded pragmatism in the concept and the definition of money is an unconvincing prelude to policy conclusions which stress the overriding importance of providing money precisely in the right quantity.” In short, if the ‘temporary-abode-of-value’ property of money is used, then the definition of money becomes simply useless for policy.

According to Radcliffe, Gurley and Shaw

Quantity of money is only a part of the wider structure of liquidity in the economy. These economists emphasize the essential characteristics of liquidity and hold that by taking into its fold all liquid assets the concept of money should be broadened. The liquidity aspect of money is more important from the policy point of view in so far it suggests that the authorities should control the general liquidity and structure of interest rates rather than the quantity of money which has been traditionally narrowly defined.

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Barter and Difficulties with Barter

Barter is a market situation in which buyers and sellers offers good for sale to one another and carry out the exchange without the use of money.The situation is found in the backward areas where tribal people sell their produce and buy their necessaries from the traders visiting them. In the absence of a generally acceptable medium of exchange, as was the case in the absence of money, one would acquire the needed with one’s own “surplus” goods. Such a transaction is called a barter transaction. When such transactions were taking place on a large scale, they constituted the barter system.

According to Jevons,

“Barter is the exchange of comparatively superflous with comparatively necessary.” This means that a barter transaction is one which involves both the sale transaction and the purchase transaction simultaneously.

Difficulties of Barter

This means that as economic system became more complex in the wake of increased human wants, barter could not continue. Money was invented and used. Under barter, people had the following difficulties:

Under the barter system all goods and services would be directly exchanged for one another. It follows that if a person A has too much good (say X) and nothing or too little of another good (say Y), he must a find person B who is precisely in the opposite position i.e, who has too much of Y and too less of X . To take up a concrete example, a fisherman who had a lot of fish and no bread could trade only if he found someone who not only had surplus bread with him but also wanted to acquire fish.

  1. This is what economists refer to as double coincidence of wants. Thus, in barter system lot of time and energy was wasted on exchange due to this difficulty. We can well imagine the nature and magnitude of these diffculties in a modern economy where human wants are multiplying and ever greater variety of goods and services is available in the market.
  2. Lack of Common Measure of Value : The second difficulty which arose under barter was that there was no common yardstick of measuring value.Each item brought to the market could bear a difficult value in relation to each one of the other items. This would give rise to a large number of exchange ratios. Competitive pricing under such conditions would become very difficult.
  3. Want of a Means of Subdivision of Value : Another difficulty of the barter system was that an individual might be faced with the difficulty of dividing his possessions. Suppose a shepherd had goat and desired to exchange it for bread. It was too costly for him to give one goat for the quantity of bread he required. How could he, then, divide his goat ? If he did so, he would simply be destroying the whole value of the goat? This difficulty of the division of each commodity for the purpose of exchange was a great inconvenience.
  4. Lack of Store of Value: Human beings try to save something in order to regulate their economic affairs over time. Under the barter system saving was every difficult. Goods lose their value the passage of time, and if value is stored in the form of goods, it will be subject to wide fluctuations. Moreover, if the commodities in the form of which value is stored are of a non-durable nature (such as wheat, skins, furs etc).,their worth is likely to go down with the passage of time. This, we find that under barter, there was no convenient, riskless and efficient means of storing value.
  5. Restricted opportunity for  exchange due to small size of the Market: Under barter it is very difficult to conclude a transaction. To affect a barter transaction, the buyers and sellers had to possess sufficient information about who is offering the goods desired to be purchased, what quantity is being offered and how many of these offers are acceptable? Lack of such information reduced the number of transactions and hence the size of the market.
  6. Difficulties of Multilateral Trade: Barter allowed trade only between two persons. This is called bilateral trade. An expanding economy requires trading among a number of persons, i.e. multi trading, Under barter, it was extremely difficult to undertake multi-lateral trade.
  7. Lack of standard of deferred payment: People could not freely borrow and lend goods on account of the absence of a calculate rate of interest. In the absence of money, many difficulties arose in the smooth of credit transaction and trade as there was no easy agreement about the mode of payment.
  8. Difficulties of taking rational decisions: A barter transaction embodies a sale as well as a purchase transaction. To enter into exchange one had to take two decisions at a time. This made rational decision making a difficult proposition.
  9. Low level of Economic Development: Due to the various exchange difficulties, barter seriously restricted the volume of transactions, reduced the size of the market and division of labor. All this kept a barter economy at a low level of economic development.

From the above transaction, it is clear that the barter system could work only in a primitive economy where life was simple, As population increased and the number of goods traded also increased, people began to think that barter should be replaced by some other convenient method of exchange. Their efforts at evolving a medium of exchange in the form of gold and silver resulted in the invention of money.

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The Origin of Money!

The first stage in the development of money can be called the introduction of commodity money. The more intelligent people tried to pick up a highly barterable commodity and use it as medium of exchange. In the hunting society, bows, arrowheads, furs and skins were used as money. In the pastoral stage-the next higher stage of civilization, these objects were replaced by sheep and cattle. Throughout most of Europe and Asia as well as in parts of Africa, animals have played the most important role because of the significance of flocks and herds in the pastoral stage. The use of animals (like cows, goats, sheep) had however, serious disadvantages. Since, all cows and goats are not alike, there could be no standard unit of money. Secondly, the supply of sheep, goats etc. could change abruptly.

The second stage in the development of money was the use of metals as money. As society developed from pastoral to commercial the character of money also changed. Man found that all the defects of commodity money could be removed if metals were used as money. Consequently, metals were used as money. Metals being useful and scarce, have other important properties such as durability, homogeneity, divisibility and portability etc. Therefore, soon the use of metals as money became more or less universal.

According to Stanley Jevons, Of gold and money independent of all convention and law.”By virtues of their being attractive, scarce and useful, gold and silver were university adopted as money even when there was no legal sanction behind them.”

The third stage in the development of money was the discovery of coinage. The use of plain metals as money had certain shortcomings. When metals were used as money, every individual had to find out for himself the value of bits of metals which were used as small amounts of money. This made the specification of value on these cognizability. Some mark had to be put on the different bits of gold or silver to give these standards of value. Thus originated the coinage system. The task of specifying the value was first carried on by merchants. Since coins carried the authority of the kings, it was gradually taken over by the state.

The fourth stage in the development of money was the printing of paper money. Use of metallic coins could be made only with a number of difficulties. The transfer of large sums of money in terms of coins was both inconvenient and risky. This type of money could be easily stolen. Since it was very inconvenient for the travelers to carry ‘money weight’ from place to place, written documents were used as temporary substitutes of money. Any person could deposit money with a wealthy merchant or a goldsmith and get a receipt for the deposit. The wealthy merchants at the distant places would honor these receipts and got the same service in return. These hundies marked the development of paper money. These paper notes gradually took the form of bank notes.

Paper money (issued by the government and central banks) is in fact fiduciary money. Fiduciary money means any form of money which has a value in exchange greater than it’s intrinsic value.

There is also in use what is call Bank Money. This includes the chequing accounts at commercial banks. These can be called money in so far as these are claims of depositors against a commercial bank and can be transferred from one party to another with the use of cheques.

We are entering the electronics age and the next logical development seems to be an electronic monetary transfer system (EMTS). This would eliminate the use of cheques and further reduce the need for currency. Through this system bank deposit balances can be transferred instantaneously to any part of the country by electronic impulses. A country-wide computer network would monitor the credits and debits of all individuals, firms, and governments as transactions take place in the economy. It may appear to be a science fiction for most but Bitcoin and electronic money have already progressed quite far!

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