Skip to Content
Personal Banking & Security
Basics of the banking industry
Open toolbar

Where paper money got its value

Back in the day, gold was the currency of choice. But carrying around large, heavy bars isn't exactly practical. That's why banks created a much easier way to give it out — without removing it from their vaults. Learn the origins of paper money.

Close transcript


Welcome back, and I just want to apologize ahead of time because I'm actually in a hotel right now because my wife is at a medical conference, and I'm using my laptop with a kind of ad hoc configuration, so it might not sound as good as it normally does, but let's just try to keep learning. So let's start off the way I start off every video, but maybe I'll do it a little different this time, so I want to start a bank, so I use 300 gold pieces, 100 to actually build a bank.

100 to build a bank, so this is where my vault, the actual physical structure, that took 100 gold pieces, and then I'm actually going to initially capitalize this bank with 200 gold pieces. You actually want to show people what it looks like for gold to be sitting in the vault so they get the idea, so my initial equity is 300 gold pieces. That's my equity or whatever the investors were that initially invested in this bank. Like all of the other examples, I start off by taking deposits. The villagers trust me, so Villager A comes and gives me, let me just do Villager A in green.

He comes and gives me his 100 gold pieces, 100 gold pieces, this is just all gold. That's an asset sitting in my vault, and then the off-setting liability for me, although this would be an asset for him, is a checking account, so account for Person A, and he can write checks against that, and we know how that can be used as actual currency or actually be used to make payments. And then Person B comes, he's a little bit richer, gives 200 gold pieces, 200 gold pieces, and he wants half of that in his checking account, and he wants the other half essentially in cash or in bank notes, as we've learned. So this is the account of B, account of Villager B, and then half of it he wants in terms of bank notes, so this liability would be bank notes outstanding for 100 gold pieces. This is 100 right here.  

This is 100, and I'll print up some bank notes, maybe he wants five 20s, so I'll give him five times, and each of the bank notes might look something like this. I have a 20 gold piece denomination, have a picture of a handsome bank founder, and it'll say Bank of SAL at the bottom, and I'll give it to him, and then he can use that for transactions with people who maybe don't like to leave a paper trail or whatever, buying a newspaper or whatever he needs to do.  

But he can use these, and then whoever he hands these to, if they have one of these 20 gold piece bills, they can come back to the Bank of SAL and actually redeem 20 gold pieces. So it's kind of like a checking account, but you don't know who actually has rights to it at any given moment in time. But anyway, we've done that in the last couple of videos, and we've shown how you can change hands and how, when someone writes a check say between A and B, you're just changing what happens in the books, and the gold never has to leave.  

But let's think about what happens now when we actually start to lend some money. So in the old example, if someone had a project that required let's say 300 gold pieces, we would actually give them the 300 gold pieces. We would actually take it out of our vaults. They would use that 300 gold pieces to hire the people or buy whatever supplies they needed to actually do their project, and then those people maybe would redeposit it back in the bank, and that process would continue.

What we're going to do now is try to think up how could we do this without the bank ever having to give the gold out. One, it's just a safety concern, and then the gold is just not an easy thing to transact with. If someone wants to sell something worth half a gold piece, do they cut it? If someone wants to sell something worth 1,000 gold pieces, it's a security risk and it weighs a lot, so what can we do?  

Let's see we did A, B, so let's do Entrepreneur C, he has an idea, let's say it's the irrigation ditch again, and he needs 300 gold pieces. So what we do is we lend him 300 gold pieces, so I have an asset, 300 gold piece loan to Entrepreneur C, and, instead of actually taking it out of my assets here and then waiting maybe for his labourers to redeposit it, I can just create a checking account for Entrepreneur C. In fact, it can be maybe part checking, maybe part cash.  

What I could do is maybe 100 of it, I can make a checking account. 100 so it's an account for C, that's a checking account, and then the other 200 I could put some more bank notes outstanding. There's 200 bank notes outstanding, so maybe I do 20, maybe he wants it in 10s, 20 times, and I give him a bunch of these things that I've printed out from the Bank of SAL. And maybe he could use this to pay his labourers, and, if the labourers later on, they don't just want to hold these pieces of paper, they can come back to the Bank of SAL and get gold in exchange for it.

And then let's say another entrepreneur comes, and he wants to build a factory. He needs 100 gold pieces. What I can do is say he needs 100 gold pieces, so I have a 100 loan, that's my asset, loan to Entrepreneur D, and then I can create a checking account for him. So this is account for D. And I know what you're thinking. It looks like I'm making money out of nowhere or I'm just increasing both the left and the right-hand side of the balance sheet for every new loan I make, and if you think about it, this was actually not that different when we issued the gold. It's just that we had to wait for the gold to come back to the bank.

This is essentially a way of keeping the gold here, and we just use these checking accounts and these bank notes as a way of transacting instead of the gold itself. So for example, let's say this Entrepreneur D, he wants to build a factory. Let's say that Person A is the person who actually builds the factory, so I have Person D, and I have Person A. Person D can write Person A a check. You know, he could write 100, you know what a check looks like. He'll sign it.

Person D, he'll say it's for a factory, and he'll write out 100 here, and he'll write it out in words, however a check is. It's something that shows, it has to be authenticated so that when A takes it back to the bank, the bank believes that D actually wrote it in his check book as opposed to someone A forging it, and in return, A is going to build D a factory. A is going to build D a factory, and then when A takes this check that he got from D and brings it back to the bank, then the bank's going to say, "Oh, okay. Well, D's going to take all this money out of his account, and we have to transfer it to A," so I could move that down, or I could just change it to A's color, and I think you get the point. All this 100 gold pieces is now A's, and once again, we did not have to change anything although we didn't have to deal with any gold.  

Now the natural question is how far can this process continue? Can a bank just continue issuing loans and checking accounts indefinitely, and essentially collecting the difference in the interest between the interest it gets on the loan and the interest it gives on the checking account? Well, no, because then a bank would take on arbitrary amounts of risk, and there are regulations, although I think a bank would do it on its own to some degree, but there are regulations called reserve requirements that tell us how much lending can a bank do relative to its actual reserves, in this case its reserves of gold. Actually, even a better definition, how much checking accounts and bank notes it can issue relative to its reserves.  

The point of this video was showing you how this loan process can occur with the gold never leaving, and the next video will actually talk about reserve requirements and think about why reserve requirements are what they are and what happens in extreme circumstances. See you in the next video.

Close Disclaimer


The material provided on this Website is for informational use only and is not intended for financial or investment advice. Bank of America and/or its partners assume no liability for any loss or damage resulting from one's reliance on the material provided. Please also note that such material is not updated regularly and that some of the information may not therefore be current. Consult with your own financial professional when making decisions regarding your financial or investment management.

Next item