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In this article we will discuss about the importance of the distinction between inside money and outside money.
First, we study the importance of the distinction between the two in a period of rising or falling prices. When there’ is inflation or deflation, a change in the purchasing power of money in the case of inside money leads to an equal change in the real values of both assets and liabilities of the private sector. Thus a change in the price level does not affect the behaviour of depositors and borrowers possessing inside money.
The monetary system also does not gain or lose in real terms by such changes in the real amount of its debt because there is an equal change in the real value of its claims against firms. Given the nominal amount of inside money, its real value varies inversely with the price level.
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In other words, a change in the price level does not lead to a wealth transfer between the private sector and the government. Instead it results only in a wealth transfer between consumers and firms, the former gaining and the latter losing when the price level falls, and vice versa.
This transfer is a distribution effect of instability in price level. But such a change in the price level, when money is of the inside variety, does not affect government behaviour and has no net effect on total wealth in the private sector.
G-S have shown that in this system the price level is determinate. A departure from the initial equilibrium price level sets in motion forces which tend to restore the initial level or a new equilibrium price level. For instance, when the price level rises, it disturbs the portfolio equilibrium of the private sector by decreasing its real money holdings relative to its bond holdings. At the new price level there will be excess real demand for money, excess real supply of bonds and goods, so that the system reverts back to the initial price level and the initial stock of nominal bonds.
This will induce sales in the bond market to raise the interest rate and expenditure in the commodity market to raise the price level. The increase in the interest rate would have a depressing effect through commodity market, thereby bringing back the initial price level, and vice versa in case of deflation.
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In the case of outside money when prices rise, the real value of cash held by exogenous economic units falls. On the contrary, when prices fall, the real value of cash held by economic units rises. Thus a change in the price level affects the behaviour of economic units possessing outside money. Thus given the nominal amount of outside money, its real value varies inversely with the price level, and each change in its real value leads to a wealth transfer between the private sector and the government. This wealth transfer affects private demands for money, goods and labour but not the government demand.
When money is of outside variety, its impact is neutral on the real variables of the economy. A monetary change causes an equi-proportionate change in prices. As a result, relative prices and interest rate would remain unchanged. An expansion in the nominal stock of outside money causes excess supply in the money market and excess demand in the commodity market.
This leads to rise in price level above its initial level. The price rise reduces the aggregate real wealth of the private sector and a decline in the real value of government debt. This brings down the real demands in all markets which restore the initial price level. In this process, there is a wealth transfer between the private sector and the government which has a net effect on aggregate demands for money, goods and labour.
Inside and Outside Money Combined:
If nominal money is composed of a combination of inside and outside money, monetary policy ceases to be neutral and some nominal stock of money is uniquely right for each state of general equilibrium. Suppose in a stationary state, the supply of inside money is doubled by the central bank through the open market purchase of the existing real bonds in the private sector.
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At the initial price level, the open market operation leads to a real transfer of bonds from the private sector to the monetary system (i.e. central bank), it thus changes the portfolio composition of the private sector whose stock of real bonds is reduced.
This brings adjustments in the various markets. There is excess money supply and excess demand in the bond market. There is also excess demand in the commodity market leading to a rise in the price level. Thus increase in the money supply leads to an increase in the price level and a decline in interest rate.
The ultimate equilibrium also involves a larger stock of capital, a higher level of real income, and a price level that is higher but proportionately less than the increase in the nominal money. Money has ceased to be neutral. Open market buying by the monetary system leads to growth in the real wealth and income accompanied by inflation. On the contrary, open market selling by the monetary system reduces real wealth and income with accompanying deflation.
According to Patinkin, the commodity market in this case can be in equilibrium at an infinite number of combinations of interest rate and price level. Hence the equilibrium condition in this market does not uniquely determine the interest rate, so that there is room for changes in the interest rate from changes arising in the bond or money markets.
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In particular, the increase in outside money will raise the interest rate, while an increase in inside money will lower it. A proportionate increase in both inside and outside money will cause a proportionate increase in the price level and leave the interest rate unchanged.
Similar conclusions regarding the neutrality or non-neutrality of money apply when the economy operates under conditions of growth. Suppose balanced growth occurs at some rate n in all the real and nominal stocks and flows of money. The relative prices and absolute price level are assumed to be constant. The stock of money consists of both inside and outside varieties and is increasing at the rate n.
The monetary expansion in the context of real growth leads to three different results:
(a) If the monetary system doubles the rate of expansion of both inside and outside money, the only effect is doubling of other nominal variables including the price level. Money is neutral in its impact on real variables of the economy.
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(b) If the monetary system doubles the rate of expansion of the inside money supply alone, there are real effects. It leads to transfer of a larger share of real bonds to the monetary system, leaving a smaller share for private investors. This causes excess supply in the money market and excess demand in the bond market.
It leads to a rise in the price level and fall in the interest rate. The adjustment in the private portfolios requires some decline in the interest rate, some increase in the growth rate of capital and income. The increase in the price level is proportionately smaller than the rise in the monetary expansion. Money is non-neutral in its effects on the real variables of the economy.
(c) If the monetary system doubles the rate of expansion of the outside money alone, there are again real effects. There is excess stock of real bonds because it remains relatively unchanged with the private sector. This leads to excess supply in the money market which induces excess demand in the commodity market. This raises the price level which operates on the bond market. The interest rate and the price level both rise above their initial equilibrium levels. Thus the real effects begin with a rise in the bond rate and restraints on real growth.
Real Balance Effect:
The distinction between inside and outside money has an important bearing in understanding the real balance effect. The real balance is not related to inside money because changes in the price level do not affect the behaviour of individuals and firms possessing inside money. Inside money possessed by them represents indebtedness of one set of individuals and firms to another.
It does not represent real wealth and is simply an indirect means of holding wealth. Thus the real balance effect is not related to inside money and the monetary system cannot influence the level of investment and the rate of capital accumulation through it.
On the other hand, it is on outside money that the operation of the real balance effect consists of government money (notes and coins) in circulation, and the outstanding government bonds which are outside money. When prices rise (or fall), the real value of government money and bonds held by individuals and firms is reduced (or increased).
According to Pesek and saving, the quantity of money relevant for the real balance effect should include both inside money and outside money. In other words, it should include demand deposits of banks as well as money issued by the government. They have argued for the inclusion of interest-bearing government securities in the inside money category. By so doing, the potency of monetary policy is enhanced in the economy.
Patinkin observes in this connection that what really matters from the viewpoint of real balance effect is not whether the issuer of the money is the government or the private banking sector, but whether assets are involved in maintaining constant the money stock. Money is wealth from the viewpoint of the real balance effect only to the extent that there is a difference between the value of money stock and the present value of the costs of maintaining that stock constant.
Therefore, from the viewpoint of real balance effect, the really relevant distinction is not between inside and outside money but between money which has no cost of production. More generally, it is between money whose marginal cost of production is less than its marginal value and money whose marginal cost of production equals its marginal value. The former represents real balance effect because it leads to positive net wealth and the latter does not.
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