Question

Explain the process by which goldsmiths could increase the money supply.

Short answer

Goldsmiths increased the money supply by practicing fractional reserve banking. They issued loans, in the form of gold receipts, more than the actual gold they had in reserves. This created 'bank money' which circulated as normal currency, thereby increasing the overall money supply.

Step-by-step solution

- Understanding the Role of Goldsmiths

Goldsmiths in the past played an important role similar to modern day bankers. People deposited gold with them for safekeeping. In exchange, the goldsmiths issued receipts which were the equivalent of today's bank notes. These receipts were used as a means of exchange (money) instead of actual gold.

- Concept of Loans and Interests

Goldsmiths noticed that holders of receipts did not always come to claim their gold back at the same time. Hence, they started lending out some of the gold (that they were supposed to safeguard) to borrowers and charged interest on these loans. This was the start of their transition into banking.

- Increase in Money Supply

The money supply increased as goldsmiths, acting as bankers, issued loans more than the gold reserves they held. These loans were in the form of receipts which circulate in society as money. This practice, known as fractional reserve banking, created 'bank money' which was more than the actual reserves, thus increasing the overall money supply.