An Old Story

Economists have traditionally explained the evolution of modern monetary systems by telling an old story, more or less a fictionalized version of the history of European money. Let's tell our own version of the old story, the story of the Bank of Fred.

Fred is a goldsmith, the only goldsmith in a small medieval city. As a goldsmith, he has a strong vault, to keep his own gold supplies in. Indeed, he has the only strong vault in town, and he stores the gold owned by other citizens for a small fee. A business that stores money in its vaults for a fee is called a bank of deposit. Naturally, to keep the records clear, Fred gives his customers receipts for their deposits.

After a while, some of Fred's customers use receipts for the gold they have deposited to make payments and settle debts. One customer may hand over a receipt in payment for a wagon, for example; and the wagon-maker may go down to Fred's Deposit Bank and take out his gold. But the wagon-maker may instead leave the gold on deposit, and pass the receipt on to the cooper (that is, the barrel-maker) to pay for some barrels. In this way, the receipts begin to circulate as money.

Thus, the receipts have become bank notes. Each receipt says, "Fred the Goldsmith will pay to the bearer, on demand, one gold florin," and these receipts are acceptable as money in Fred's town because the people have faith that Fred can and will honor that promise -- that is, the bank-notes are "fiduciary money." A bank that issues bank-notes that circulate as fiduciary money is known as a "Bank of Issue," and Fred's Goldsmith Shop has become a bank of issue.

Bank of Issue