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United States One Dollar Bill

6 - The Introduction of Money Substitutes

Money Substitutes

It is usually impractical to carry significant quantities of metal around should we wish to make an array of purchases. The greater quantity of gold and silver money we own, the more inconvenient and the greater trouble to both to keep and transport it.

Similarly, in the field of commerce, it is too cumbersome to deal with stocks of metal moving in and out of a business in return for providing a particular service.

Instead, we could deposit our gold and silver at a bank and receive a receipt of our holding in return – let’s call this a bank note. The bank note states that we have a particular holding of gold and silver money on deposit at the bank.

Since all members of society eventually come to use the services of such banks, bank notes begin to circulate in place of the physical gold and silver deposits. The bank notes pass between parties during economic transactions, shifting the entitlement to the gold and silver money without the need to move the physical metal.

“In this way, receipts for money come more and more to function as money substitutes. Fewer and fewer transactions move the actual gold; in more and more cases paper titles to the gold are used instead.”

The Money Supply Including Money Substitutes

Let us assume for the moment that the total amount of gold stock is 1000 ounces, split between several different banks. Furthermore, let us assume that 600 bank notes have been issued, each equivalent to 1 ounce of gold and convertible on demand into gold.

What impact do these bank notes have on the money supply? Since 600 bank notes have been issued and are held in public hands, does it mean that the effective money supply in the economy has increased even though the stock of gold has remained the same? No! The money substitutes are simply receipts for actually-deposited gold. The 600 notes can be used as money, but only as a convenient stand-in for the gold, not as an increment. The gold in the vault is then no longer a part of the effective money supply, but is held as a reserve for its receipt, to be claimed whenever desired by its owner. An increase or decrease in the use of substitutes, then, exerts no change on the money supply. Only the form of the supply is changed, not the total.

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