Competition between inside and outside money: the two-circulation approach

We present a model to analyze different equilibria that exist in an economy in which agents can choose the means of payment to use in trade; i.e., inside or outside money. Our approach departs from the usual explanation of competition as a phenomenon related to money functions (means of payment and store of value). We interpret competition from the two circulations perspective, developed by Tooke and Smith: income circulation, between entrepreneurs and workers, and capital circulation, between entrepreneurs. We claim that monetary authorities can generally assure that outside money is used in income circulation transactions regardless of workers' choice. However, authorities cannot affect the means of payment used in equilibrium in capital circulation transactions. If half of entrepreneurs adopt inside money instead of outside money, all of them will choose the former regardless of authorities' decisions. The distinction between 'circulations' is crucial to explain the equilibrium that corresponds to Tooke's description: outside money is chosen for income circulation transactions whereas inside money (assumed to be less costly) is chosen in capital circulation.