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Development of Modern Banking Starting Scenario Goldsmiths, who had safes, would hold other people's gold in safekeeping, giving a deposit receipt and charging a fee. When the depositor wanted to use his gold, he turned in (redeemed) the deposit receipt and got his gold back. When the first depositor gave the gold to a second person for goods or services, the second person might then deposit the gold back with the goldsmith. Gold was the medium of exchange (i.e., money). Therefore, there was just as much money in circulation as there was gold to be circulated. INNOVATIONS Standardized Deposit Receipts as Money The goldsmiths standardized their deposit receipts. The depositor then could simply give the deposit receipt in payment for goods or services, rather than have to collect his gold from the goldsmith and give the gold in payment. Result: the gold itself could stay on deposit indefinitely. The gold receipts acted as money. This would be successful as long as both parties to the transaction believed they could redeem the receipts for gold anytime they wanted to. Every dollar of gold deposit receipts was backed by a dollar of gold on deposit with the goldsmith. The amount of money in circulation was still the same as the amount of gold available to be circulated. -2- Fractional Reserve Banking Goldsmiths noticed that only a small fraction of the gold ever had to be paid out for redeemed deposit receipts. Therefore, the goldsmiths could a. loan out part of the gold on deposit (and collect a fee) or b. issue more deposit receipts as loans (and collect a fee) Borrowers gave the goldsmiths notes promising to pay back the loans (promissory notes). As long as the deposit receipts continued to be circulated as currency and were not presented for redemption, the goldsmiths did not have to a dollar of gold on deposit for every dollar of deposit receipts circulating. Therefore the amount of money in circulation was GREATER than the amount of gold available to be circulated. THE GOLDSMITHS HAD "CREATED" MONEY. Example: Before Loan Assets Gold $1,000 Total $1,000 Liabilities Receipts $1,000 Total $1,000 Assets Gold $1,000 Loans 4,000 Total $5,000 After Loan Liabilities Receipts $5,000 Total $5,000 -3- Bank Safety Goldsmiths became banks, and their deposit receipts became banknotes. A banknote is an unsecured promise on the part of the bank to pay the face amount of the note to the holder. If more holders of notes presented their notes for redemption than the bank had gold, only the first presenters would get gold. The bank would then fail, and the latecomers would get nothing. Therefore, rumors of a gold shortage at a bank will cause a run on the bank - large number of depositors will present their notes for redemption, assuring that the bank will indeed run out of gold and cause failure of the bank. Deposit Banking Banks realized that the economy - and their profits - would increase if each bank accepted the banknotes of other banks. This allowed the creation of checking accounts and the use of both banknotes and checking accounts over a wide geographic area.
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