From Coins to Bank Deposit money
The evolution of modern money
Precious metals have been used as money for thousands of years. Even as lumps of metal carried around in sacks, they still functioned quite well as money.
Coins made from these precious metals were an early improvement introduced by many societies including the Greeks and Romans. Coins had the clear advantage that they did not have to be weighed out each time they were used. But the use of coins enabled many rulers to increase their spending by adding base metals to the coins and thereby increasing the number of coins. This debasement frequently led to problems of inflation as the money supply increased too rapidly.
Paper money has a much more recent origin. In Britain, it was issued by goldsmiths. Wealthy merchants and individuals would deposit their gold with goldsmiths, whose businesses required them to have safe storage facilities. The goldsmith would issue a receipt for the gold.
It was soon realised that it was much easier to use these receipts to buy goods than for the purchaser to withdraw gold, pay it to the seller of the goods, and for the seller then to redeposit it with the goldsmith. It was easier still if these receipts were issued in fixed denominations. Thus goldsmiths’ receipts became very much like modern banknotes.
The alternative was for a purchaser to write a note instructing the goldsmith to transfer a certain amount of gold to the seller. These notes were very much like modern cheques.
Goldsmiths also realised that only a small fraction of the gold in their vaults would be withdrawn at any one time, and even then there would be other people who were making new deposits. So they found they could lend out some of the gold and make money by charging interest. When these loans of gold were redeposited back with goldsmiths, new notes were issued in addition to the original ones.
Soon the total value of the notes issued considerably exceeded the total value of the gold! The notes were only partly backed by gold. This is known as a system of fractional backing.
It was a short step from goldsmiths’ notes to banknotes and bank loans. Banks, often originally operating as goldsmiths, issued their own banknotes in excess of the gold in their vaults, just as the goldsmiths had done.
Today banks in Australia and most other countries do not issue their own notes, but their loans still exceed their deposits of cash. This process of credit creation is examined in the textbook. Today it is bank deposits that form the bulk of money supply. Only a fraction of these deposits are in cash. The rest are simply bookkeeping entries created by the banks.
Modern banknotes are not backed by gold. A currency not backed by gold (and no currencies in the world today are) is known as a fiat currency: a currency whose supply depends on the will of government. The issuing of currency not backed by gold is known as fiduciary issue. This means currency issued on trust. If the government is prepared and able to match the supply of currency to the requirements of the economy, this will be adequate to ensure the stability of the currency. The backing of gold will be unnecessary.
Questions
1. If money is not backed by gold, what gives it its value?
2. If the money that banks have created vastly exceeds the amount of cash in the economy, does this mean that there is too much money in the economy?
LINKS
Paper Money URL:
Issuing of currency