Historical Currency

In the made up world with the islands of Islandia and Rockton, sticks and metal were the individual currencies of each island.  When the two islands wanted to trade with each other, it worked for a while, but then one currency eventually dominated.  That currency was the metal because it was valuable to everyone.  So just like how the sticks came about as the currency for Islandia, the people found the most common acceptable medium of exchange for the whole world (the two islands) through the open market system was shiny metal.  There were no governments or laws written to create the currency, it developed naturally through the barter market and the varied products it offered.

Throughout most of modern history, it was metals that was accepted as currency.  The first metal to be used as currency, gold and silver bars, were around 4000 BC in Egypt and Mesopotamia.  By around 650 BC, gold was the first used in it's modern circle form in Lydia (Turkey).
  

Later in the 6th century BC, Greece minted silver coins.


Throughout this period, the amount of gold and silver were limited by mining activities.  Whenever a country would find a large deposit, they had a boom to their economy with the increase in currency, but at the same time, the boom also created inflation (higher prices of all other products) which hurt those people that stored their wealth in these coins, but it also made it easier to earn more by the selling of their own products.

The governments that controlled the minting and distribution of coins, as well as the collection of taxes, had an advantage that nobody else had.  Governments throughout history have deployed tactics of debasement and devaluation.  Some governments collected the coins through taxes and clipped or shaved each coin, thereby being able to melt down the shavings and re-mint new coins thereby increasing the governments ability to pay their bills.  Other governments melted down all of the metal coins and mixed other metals into the coins, thereby diluting the purity of the coins and minting additional coins.  This also created inflation as the new amount of currency in the system became more known and questioned. But since this debasement was done without public knowledge, the prices didn't rise as quickly as if a new deposit of gold or silver was found, therefore the governments were able to purchase more with their currency than anyone else.

By the 16th and 17th centuries, Goldsmith's who would form the precious metals into jewelry started to get people asking if they could use their vaults to store their own gold/silver coins as it was becoming unsafe through theft to store mass quantities at their own homes.  The goldsmith's would do it and charge those patrons a small storage fee.  The patron would get a receipt of this deposit in order to claim their gold/silver at any time.  Some depositors allowed the Goldsmith to even loan out their coins and charge interest to worthy borrowers, in exchange for the waiving of the depositors storage fee.  This way, the Goldsmith could make extra money by finding worth borrowers that would repay timely and in full, and be able to collect some interest on those loans for pure profit.

Eventually, the Goldsmith's vaults became a very common place for everyone to store their coins.  Since almost everyone's coins were in the local Goldsmith's vault, people actually began trading their vault receipts instead of withdrawing the coins and taking them back to pay for their goods or services.  These paper receipts were so much more convenient than carrying around a bag or pocket full of coins.

18th Century Goldsmith bank receipt

The Goldsmith's used this activity to their advantage.  The smarter Goldsmith's first figured out that not everyone came back to withdraw their coins.  In fact, a small percentage of people did.  And if they did, they really didn't care if it was their exact coins that they received, just similar quantity and quality.  The Goldsmith's used this opportunity to lend out more vault receipts than the amount of deposited coins in the vault.  This created more "money" in the economy because the receipts that he loaned to borrowers was then used to purchase whatever the borrower needed.  In the same way the governments debased or devalued the coin currency, Goldsmith's did the same thing by loaning additional receipts that were not backed by an actual deposit.  If this sounds like fraud to you, it's because it is.  In essence, the Goldsmith's created money out of thin air, by just writing up another receipt.  This was the beginning of our modern day fractional reserve banking system.

It's called a fractional reserve banking system because there's a fraction of the deposits on hand in the bank vs. the amount of money they loan out.  For most of history, there was a fear by the Goldsmith's and later the bankers, that at any moment, their depositors would come in to withdraw their coins (a bank run).  If more people came in to withdraw coins than they had on hand, they would instantly go bankrupt and be out of business.  (Think "It's a Wonderful Life" where Jimmy Stewart explains to the people he doesn't have their money, Fred and Ethel have it for their car or house.  Then he's over-joyed at closing time because he was able to keep $2 and stay in business)

Therefore, this fear kept them in line to only lend out a modest amount over their deposits. In modern times, this fear was eliminated with the creation of Central Banks, and even FDIC insured deposits, as it took away the wanting of those depositors to make a run on the banks (in theory).  But that's for another time.

Next we will backtrack a little bit and discuss the Government's role in currency in a little bit more detail throughout history.