This paper uses a new monetarist framework to present and explain the basic elements of a non-monetarist theory of money, classical banking theory, by modeling acceptance banking, the form of banking that was dominant during the 19th century when the theory was developed. The most important principle of classical banking theory is that the money supply must be able to expand to meet unpredictable “needs of trade.” Underlying this approach is the view that the optimal quantity of money is inherently stochastic due to real productivity shocks that are constantly changing the optimal level of economic activity. The basic premise of classical banking theory is that transactions are typically paid for by incurring debt, and that the role of the banking system is the monetization of this transaction-based debt. In this framework bank liabilities are the principal form of money, and they circulate because they are backed by debt that can be repaid by depositing bank liabilities into one’s account. When fiat money is introduced into the model we find that non-banks are willing to carry fiat money from one period to the next because it is a non-interest-bearing asset and reduces the costs of borrowing to transact.The paper also explains how the model can be reinterpreted as a model of the modern banking system.
