Many have heard the phrase "Money makes the world go round", but where does money come from? The United States, like most other countries today, has a fractional reserve banking system in which only a fraction of the total money supply is held in reserve as currency. Early traders began to use gold in making transactions; they soon realized that it was both unsafe and inconvenient to carry gold and to have it weighed every time they negotiated a transaction. By the late sixteenth century, they had begun to deposit their gold with goldsmiths, who would store it in vaults for a fee. On receiving a gold deposit, the goldsmith would issue a receipt to the depositor. Soon people were paying for goods with goldsmiths' receipts, which served as the first kind of paper money. On receiving a gold deposit, the goldsmith would issue a receipt to the depositor. Soon people were paying for goods with goldsmiths' receipts, which served as the first kind of paper money. The goldsmiths observed that the amount of gold being deposited with them in any week or month was likely to exceed the amount that was being withdrawn. Someone came up with the idea that paper receipts could be issued in excess of the amount of gold held. Goldsmiths would put these receipts, which were redeemable in gold, into circulation by making interest-earning loans to merchants, producers, and consumers. Borrowers were willing to accept loans in the form of gold receipts because the receipts were accepted as a medium of exchange in the marketplace. This was the beginning of the fractional reserve system of banking, in which reserves in bank vaults are a fraction of the total money supply. The fractional reserve has two significant characteristics: money creation and reserve which is defined as Banks can create money through lending, and bank panics and regulation: Banks that operate on the basis of fractional reserves are vulnerable to "panics" or "runs"... [continues]
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