Bank of Issue

Then Fred makes a discovery. Fred finds that only a small percent of his receipts or bank notes are cashed in for gold in any given period. That means Fred can issue more notes than he has gold in his vaults, since he can (almost) always meet the small daily demand for redemption out of gold in the vaults.

One day Ronald the Peasant comes in to ask for a loan. Ronald is doing pretty well, and wants to buy a second ox so he can use a two-ox team to cultivate a larger field. Fred doesn't have any gold to loan -- so he writes out some bank-notes and gives them to Ronald the Peasant as a loan. The ox-seller accepts the bank-notes in payment for the ox, and at the end of the year, Ronald sells some of his crop for bank-notes, and uses those bank-notes to repay the loan with interest. Fred has created money out of nothing (but trust)! And creating money is a profitable business. His profit from this business comes from interest on loans of these new banknotes.

In general, a bank of issue creates fiduciary money, either in the form of bank-notes or some other form, and lends them at a profit. Since the money is created from nothing, the interest may be mostly profits. Mostly, because banks have costs. In a system of competitive banking, competition may limit bank profits. But the Bank of Fred, a monopoly bank of issue in a small medieval town, faces no limit from competition.

The Limit