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Fractional Gold Standard/Fiat Currency

Fractional Gold Standard/Fiat Currency

Author: Kate Eskra

Identify key developments in the fractional reserve system.

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Source: Image of bank run, public domain,

Video Transcription

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Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on the Fractional Gold Standard and Fiat Currency. As always, my key terms are in red, and my examples are in green. In this tutorial we'll talk about what a fractional reserve system is, and how it developed in our country. We'll also talk about how the United States transitioned from backing its currency with gold at one point, and moved more towards a fiat and fiduciary currency.

So when people were using gold as a form of money, banks started to emerge as intermediaries. And what they did was they allowed people to store their gold safely. It really wasn't safe to carry all that gold around with you, or to store it in your home. It also though allowed people to write checks on their deposits, without having to physically remove the gold from the bank.

So then banks started to print paper money. And this paper money represented a designated amount of gold. And this paper money was a lot easier to trade than the gold itself, actually. And when it is easy to access a form of money and spend it right now to use it as a medium of exchange, we call that liquidity. So a form of money is liquid when it's easy to use it right now to get what we want. So this paper money was liquid.

Why is it that people actually valued this paper money? We know that the paper itself had no intrinsic value. It's not a commodity. Well, it had value because people believed that they could actually convert it to gold. So when that belief exists, that's when a form of money is actually representative. Because the paper now represents something of value, the gold.

So let's talk about for a second how banks make money. And I know you're pretty aware of this. But think about it. If banks just simply were there to store our money for us, they wouldn't make any money. And they would not profit. So back then, banks were already figuring out that hey, here's what we can do. We can pay interest to people who are depositing money into a deposit account or a checking account, but we'll make money by charging a higher interest rate to loan out some of that money to other people. And that's where they got their revenue.

So that is what encouraged this fractional system to develop. So they're issuing paper money, and banks are realizing that they can make more loans and then more money by printing more paper currency than actual gold they had stored in their vaults. So when banks hold only a fraction of their deposits in actual gold, this is when we move to a fractional reserve system.

So this sounds kind of shady. Is it OK? Well, yeah it's OK, as long as some things don't go wrong. I mean what are the chances that everyone will show up at the bank or ATMs today and demand all of their money, let's say at your bank? The chances aren't very good that that's going to happen. And so banks were banking on the fact that not everyone would show up demanding their money. So that's why they could print more.

So as long as the demand for gold on any given day was less than the gold held in reserve, this system is fine. And what it did was allow banks to make more loans and then earn more interest. But obviously, we know the problem is if many people show up demanding gold that was held in their accounts, then the bank obviously can't meet all of those demands. Because there's more notes out than gold reserves actually being held.

And if that's the case, if everybody shows up demanding what they're owed, than the bank fails, or ends up going bankrupt. So I want you to think about this. I always think about the scene from It's a Wonderful Life, where there's a bank run. Everybody comes demanding their money. And he has to explain to everybody, look, no. I don't have all-- it's not all here. Your money is in his house, and your money is in his business. So bank runs happened. If you think about that scene, this is when bank customers show up demanding all of their money at once.

And it becomes a panic situation when this happens in large quantities. So when the stock market plummeted at the very beginning of the Great Depression in 1929, there were many bank runs on the same day. So that becomes a panic. And we call it a panic because people are panicking as a result of something going on majorly in the economy. And they all run to the banks to get all of their money.

Well, the first people who get there get their money, and then everybody else doesn't. Because it's just not there. It's all out in the form of loans for others. So these bank runs and panics actually take a bad situation and make it a whole lot worse. When banks start failing, it creates less confidence and a whole lot more worry and panic from consumers. And then how in the world do you get the economy back on track in that case? Because our economy is so dependent on people being confident to spend their money and take out loans, and all of those things. So this is not a good situation.

When the stock market crashed, investors started trading in gold and other commodities. This is going to cause the price of gold to go up. And then people started trading in dollars for gold and hoarding their gold, because they didn't have trust in the banking system. So confidence in our US currency went way down.

So in this Gold Reserve Act of 1934 then, FDR outlaws private ownership of gold. He needs to do something to protect our currency and to get things back on track. So by executive order, people are ordered to bring back their gold to the Federal Reserve in exchange for dollars. And this was to prevent the hoarding and to protect our currency. This in fact, suspended the gold standard at this time.

What he also did this Act was increase the price of gold to $35 an ounce. It had been only $20 per ounce. So now $1 is defined as 1/35th of an ounce of gold. But keep in mind, it's no longer redeemable for gold. We had some international exchange still going on, but in our country you couldn't bring in your dollars and exchange it for gold.

When the Great Depression ended, it meant that countries could go back to a modified type of gold standard. And most countries actually ended up valuing their currencies based on the US dollar's definition of it, since we owned most of the gold in the world at that time.

But then as countries recovered from World War II, especially like Germany and Japan, our share of economic output starts to kind of drop relative to the rest of the world. And because of that, our gold stock, the amount of gold we held, fell as well. And so the US Treasury's fraction of gold relative to currency fell.

We had a lot of problems in the early '70s, late '60s, early '70s. And we started having a negative balance of payments, increasing debt, and inflation. What Nixon does in 1971 was pretty shocking. And he was just attempting to stabilize the United States economy. He completely ends the convertibility between US dollars and gold. He completely takes us off the gold standard.

So this is the point where we have no tie to gold at all. So it's not representative anymore. What's going to give the dollar its value? It does not any longer represent 1/35th of an ounce of gold. Well it's value now is completely based on people's trust in our Federal Reserve System. And that's what we call a fiduciary currency. So fiduciary currency is the currency whose value is based on trust or faith that it has that value.

Today our paper currency is not valuable in and of itself. I mean how much is that little piece of paper actually worth itself? Nothing, almost nothing. So it's not a commodity currency. That's what a commodity is. Something that's valuable in and of itself. It's also no longer backed by gold. So it's not a representative currency.

It is valuable though. Everybody places value on dollars, because people accept them widely as a form of payment. That's what we know as a fiat currency. Fiat money is money that's recognized legal tender that is nonconvertible. So we can't convert it to anything else of value. And it has no value in and of itself.

So in this tutorial we looked at what the fractional reserve system is, and how it developed in the United States. And we looked at how the United States transitioned from backing its currency with gold, moving to a fiat and fiduciary currency. Thanks so much for listening. Have a great day.

Terms to Know
Fiat Money

Money that is a recognized legal tender that is non-convertible and has no intrinsic value.

Fiduciary Currency

A currency whose value is based on “trust” or “faith” in its value.