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fractional reserve banking
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fractional reserve banking

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Beginning in 16th century, savers looking to keep their valuables in safekeeping depositories deposited gold and silver at goldsmiths, receiving in exchange a note for their deposit. These notes gained acceptance as a medium of exchange for commercial transactions and thus became as an early form of circulating paper money.

As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born.