During the 17th century, people began to leave their valuables, especially their gold and silver, in the strong rooms of goldsmith for safe keeping. The goldsmith issued receipts for the precious metal deposited with them. These receipts were paper claims to gold – they could be exchanged for gold at any time. In time, the depositors began to use these receipts as a means of settling their debts. They would write on the receipts a note to the goldsmith informing him that they had transferred ownership of note to the goldsmith informing him that they had transferred ownership of the gold to someone else. As this practice became more popular, the goldsmith began to issue receipts in convenient denominations, such as 1$, 5$, 10$ and so on. They also made the receipts payable to the bearer, which meant that anyone possessing such a receipt could exchange it for gold. When these claims to gold became payable to the bearer, they became the first fully-fledged banknotes. They were acceptable as money because people knew that they could convert them into gold at any time. The notes were fully backed by the gold in the goldsmiths’ strong rooms.
The next stage in the development of paper money came when the goldsmith-bankers began to issue banknotes in excess of the value of the gold they held. They found that they could do this because more and more people were using banknotes, and fewer and fewer were withdrawing gold in order to make payments. Although, on any one day, there would be people coming in to exchange their banknotes for gold, others would be coming in to deposit gold. Most of the gold was lying idle in the strong rooms. The goldsmith-bankers believed that they could safely increase the issue of banknotes and still meet all likely demands for gold from the people holding their banknotes.
Up to this point, the goldsmith-bankers had not been creating money. People had simply exchanges one form of money (gold) for another form of money (banknotes). Now, however, money was being created, because the bankers were issuing banknotes to a greater value than the gold they held. This additional money was used to make loans, on which the banks charged a rate of interest. That part of a note issue which is not backed by gold is described as a fiduciary issue.
In these early days, anyone could set up in business as a banker and issue banknotes. This led to many bank failures because bankers were tempted to over-issue banknotes and then found themselves unable to meet exceptional demands from people wishing to exchange their banknotes for gold. The government was obliged to regulate banking, and the Bank of England is now the only note-issuing bank in England and Wales. A few banks in Scotland and Northern Ireland still retain the right to issue notes.
3.3.1 Token money
Until the outbreak of the First World War, a British banknote was convertible into gold. This is no longer the case, although the wording on our banknotes has remained unchanged. The whole of our note issue is fiduciary. Similarly, the value of the metal content of our coins is only a very small percentage of their money value. Our currency, both notes and coins, is token money.
3.4 Bank deposits
3.4.1 Bank deposits are claims to cash
Bank deposits may be seen as claims to cash (notes and coin) because they can be converted into cash, either on demand or after some period of notice. The banks, however, do not have to keep cash reserved equal to the total value of their deposits. People with bank deposits normally use cash for smaller payments; for larger payments they tend to use their cheque books. This means that bank depositors will normally only demanded a small percentage of their bank deposits in the form of cash.
Just as the goldsmith-bankers were able to issue banknotes to a greater value than their gold reserves, so modern bankers are able to create bank deposits to a much greater value than their cash reserves.
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