A Goldsmith Exercise for Learning Money Creation

Abstract

In this article, the authors outline a classroom exercise involving goldsmiths designed to improve undergraduate students’ understanding of how banks create money. This concept is important to macroeconomics and money and banking courses, yet students frequently struggle with it, largely due to the nonphysical nature of deposits and reserves. In contrast, gold-based banking systems tend to be more intuitive because of the physical nature of gold. By simulating interactions among a goldsmith, a depositor, a merchant, and a borrower in a gold-based system, students gain a deeper understanding of reserves and money creation. In particular, the exercise illuminates the intricate link between lending and the creation of new money, and highlights the importance of fractional reserve banking and reserve deposits.

Keywords:

• banking
• classroom experiments
• medium of exchange
• money creation

JEL codes:

• A22
• E40
• E51

Acknowledgments

The authors are grateful to participants in the Teaching Innovations Program, the Southern Economic Association annual meetings, the first annual AEA Conference on Teaching Economics, Denise Hazlett and KimMarie McGoldrick, and two anonymous referees for comments on earlier drafts.

This article is based on a paper that was presented at the National Conference on Teaching Economics held at Stanford University on June 1–3, 2011.

Notes

1. We believe that working through a hands-on exercise about the very early stages of money creation enables students to develop a deeper understanding of the modern process than they would obtain from simply discussing electronic reserves and fiat money. Studies show that actively engaging students in the learning process increases the depth and duration of learning. See Yamarik (2007) for a specific example and Miller and Rebelein (2012) for a survey of literature on this issue.

2. Our class periods were 75 minutes. The time required could be reduced by eliminating the fourth interaction or by postponing the debriefing after the interactions to a subsequent class period.

3. See Barkley, Cross and, Major (2005) for a discussion of the pros and cons of different methods of forming groups. We chose to assign students to groups by having them count off up to the number of groups to be formed.

4. We found it helpful if the initial endowments have a physical form, such as candy, balloons (inflated), a small bag of rocks, or some other bulky, heavy, or hard-to-carry items. This reinforces the high transportation cost of gold and makes it more interesting to see if the willingness to accept gold notes increases when students have to leave their group and the transportation costs increase. We find that using physical money, such as Hershey's kisses, where one piece equals one $50 gold coin, emphasizes the drawbacks of commodity money and the benefits of using representative paper money.

5. We found that a tangible threat of loss of their gold is important to discourage students from using gold to make purchases. We chose this high probability of theft to encourage Depositors to deposit their gold and because it easily can be enforced with a coin toss.

6. The instructions presented in this section are summarized on a single sheet in an Appendix A, available on each author's Web site.

7. For example, Depositors differ in their desire to receive interest from the Goldsmith, the term of the deposit, the inclusion of restrictive covenants (the Goldsmith cannot melt down the gold, for example), and the inclusion of channels for recourse if the Goldsmith cannot pay the Depositor back the coins. Some instructors may prefer to use the term “deposit slip” rather than IOU to indicate the fact that the Depositor has deposited his or her gold with the Goldsmith. We find using the term IOU better conveys to students the fact that the Goldsmith has incurred a liability in the deposit transaction.

8. The Depositor could be instructed to buy something from the Merchant in his or her group. However, having the notes issued by a Goldsmith circulate outside the Goldsmith's group is necessary in later stages of the exercise (and in the extensions) in order to generate uncertainty about the backing ratio behind notes issued by different Goldsmiths.

9. Sometimes, students try to use new IOUs to create a claim by the Merchant on the assets of the Depositor. Such practices should be discouraged by pointing out that the trustworthiness of the Depositor is unknown, and he or she may or may not be able to make good on this debt in the future. In contrast, the Goldsmiths are more trustworthy because they have a reputation to protect.

10. We assume no discounting of the gold notes takes place.

11. Students may raise the possibility of scrip, in which the Borrower uses the loan agreement to purchase goods and services. Usually, however, asking Merchants if they are willing to accept this over either gold coins or gold notes, which have been established as a medium of exchange, eliminates scrip as an option.

12. Note that this extension does not build on the first one, so instructors wishing to use this extension should remind students to return to the situation without loan default.

13. Alternatively, the instructor could have the Goldsmith make additional loans. We prefer having the Depositor withdraw his or her deposits because that leads to more substantial declines in the backing ratio.