The Simplest Model with Government Money

Abstract

Money is created in two fundamentally different ways. On the one hand there is outside money which is created whenever a government pays for something by making a draft on its central bank or by paying for something with banknotes, and which is extinguished when a payment is made by a member of the public to the government, typically in the form of taxes. This kind of money we may call government money, since it is issued by public institutions, namely the central bank or the Treasury department of central government. Government money is usually called central bank money or high-powered money in the literature. On the other hand there is inside money, which is created by commercial banks when they make loans, and which ceases to exist when loans are repaid. This second kind of money will be called private money, since it is issued by private institutions, namely private banks.