We think of money in the bank and money in our wallets as being the same thing. A bank deposit is ‘Inside Money’ while bank notes in your wallet, is ‘Outside Money’. These two types of money do not mix just like oil and water.
Inside Money in the bank is imagined into existence by banks in the process of creating a loan. Outside Money or Government Money is imagined into existence by the government.
If your local bank grants you a loan it creates a deposit in your account. This deposit is a liability on the bank’s balance sheet against which it holds an asset in the form of loan to you. If you use the borrowed money to purchase a house and the seller is a customer of the same bank, the liability never leaves the bank. If the seller is a customer of another bank, the two banks will settle the transfer at the central bank but the liability will never leave the banking system. Inside Money exists only on a bank ledger and can never take physical form. To be specific and a bit technical, it is a short-dated liability of the banking system.
Outside Money is imagined into existence by the government making a payment. It is like an undated government IOU. When the government pays a civil servant, it creates brand new Outside Money. The government then typically seeks to destroy an equal amount of Outside Money to offset this monetary expansion. This process is called monetary sterilization. Governments destroy their monetary creation in order to maintain confidence in the currency. If a government were to exponentially increase the stock of Outside Money, recipients would lose confidence in the currency and seek to convert it into real assets.
Monetary sterilization happens when the government issues debt that is bought by the private sector, thus taking Outside Money out of circulation and replacing it with government bonds that cannot be so easily spent. It also happens when a government imposes taxes and where the tax receipts are effectively torn up to maintain confidence in the currency.