Variations in the ratio between the stock of money and the demand for money must ultimately exert an influence on the rate of interest also; but this occurs in a different way from that popularly imagined. There is no direct connection between the rate of interest and the amount of money held by the individuals who participate in the transactions of the market; there is only an indirect connection operating in a roundabout way through the displacements in the social distribution of income and wealth which occur as a consequence of variations in the objective exchange value of money.

An increase in the stock of money in the broader sense caused by an issue of fiduciary media means a displacement of the social distribution of property in favor of the issuer. If the fiduciary media are issued by the banks, then this displacement is particularly favorable to the accumulation of capital, for in such a case the issuing body employs the additional wealth that it receives solely for productive purposes, whether directly by initiating and carrying through a process of production or indirectly by lending to producers.

Assuming uniformity of procedure, the credit-issuing banks are able to extend their issues indefinitely. It is within their power to stimulate the demand for capital by reducing the rate of interest on loans, and, except for the limits mentioned above, to go so far in this as the cost of granting the loans permits. In doing this they force their competitors in the loan market, that is all those who do not lend fiduciary media which they have created themselves, to make a corresponding reduction in the rate of interest also.

Our theory of banking, like that of the currency principle, leads ultimately to a theory of business cycles. It is true that the Currency School did not inquire thoroughly into even this problem. It did not ask what consequences follow from the unrestricted extension of credit on the part of the credit-issuing banks; it did not even inquire whether it was possible for them permanently to depress the natural rate of interest.

Credit-issuing banks as a rule give preference to short-term loans as investments. Often the law compels them to do this, but in any case they would be forced to do it by public opinion. But the significance of this preference has nothing to do with the greater ease with which it is generally, but erroneously, supposed to allow the fiduciary media to be redeemed.

The solution of the problem of soundness is no more difficult for the credit-issuing banks than for the credit-negotiating banks. If the fiduciary media are issued only on good security and if a guarantee fund is created out of the bank’s share capital for the purpose of covering losses, for even under prudent management losses cannot always be avoided, then the bank can put itself in a position to redeem in full the fiduciary media that it issues, although not within the term specified in its promises to pay.

Since it is not the object of a redemption fund to provide for the redemption of such money substitutes as are returned to the bank because of lack of confidence in their goodness, but only to provide the bank’s customers with the media of exchange necessary for dealing with persons who are not among its customers, it is obvious that such a fund might be composed at least in part of such things as, without being money, can be used like money for dealings with outsiders.

There is nothing remarkable in the fact that money substitutes, as completely liquid claims to money against persons whose capacity to pay is beyond all doubt, have a value as great as the sums of money to which they refer Admittedly, the question does arise: Are there any persons whose capacity to pay is so completely certain as to be quite beyond all doubt?

The view has sometimes been expressed that if an issuing body wishes to secure equivalence between its fiduciary media and the money to which they refer, it should take precautions so as to be able to redeem those fiduciary media that are returned to it through lack of confidence on the part of the holders. It is impossible to subscribe to this view; for it completely fails to recognize the significance and object of a conversion fund.

Recognition of the fact, which had been pointed out before the time of Ricardo, that there is no way in which an issuer of fiduciary media can protect itself against the consequences of a panic or avoid succumbing to any serious run, may lead, if one likes, to a demand that the creation of fiduciary media should be prohibited. Many writers have adopted this attitude.