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The second type of money in our economy is bank dollars-transaction deposits at various types of financial institution. These deposits are convertible on demand into definitive money. They may also be used directly in payment, with ownership being transferred by check or by other means. Bank dollars did once exist in the form of banknotes, but today the issue of banknotes is in most countries a monopoly of the state.

In the united States, transactions deposits are offered by commercial banks, by thrifts, and by credit unions, in many other countries, they are also offered by the post office. The total amount of transactions deposits in the United States in April 2001 was $806 billion.

As we saw in chapter 2, a bank dollar  is simply a bank’s IOU: it is a bank’s promise to pay one dollar of definitive money on demand. Payment in bank dollars developed as an alternative to payment in definitive money on the one hand and to private promises of payment on the other. Payment in bank dollars often involves lower transaction costs than payment in definitive money. And promises of payment by banks are often more credible than promises of payment individuals or firms.

Payment with dollar bills (with hand-to-hand currency) is straightforward: you just hand them over. Payment with deposits is more complicated. You need some way to transfer ownership of the deposit to the recipient. There are number of ways to do this.

If our definitive money, unlike gold, has no intrinsic value and is not convertible, then why do people accept it in payment? The main reason is that they know they can pass it on to others in payment. Their ability to do this is reinforced by the status of definitive money as legal tender. This means that if you pay a debt in Fed dollars, the debt is legally settled. Your creditor cannot demand payment in some other form-say in gold. The general acceptability of definitive money is also reinforced by the federal government’s willingness to accept it in payment of taxes.

Without the constraint of convertibility, what stops a government from creating as much fiat money as it wishes? Nothing at all. This unrestricted power to create money can be both a blessing and a curse. On the one hand, it allows the government to ensure that the quantity of money grows to meet the needs of a growing economy: this could be  problem in the days when definitive money was gold or silver. On the other hand, there is nothing to prevent a government from creating money to pay its own bills. The unrestrained creation of money for this reason is the main cause of inflation around the world

Fed dollars were once convertible into gold. Today, that is no longer true. You cannot take your dollar bill to the Fed and demand payment in “real money.” All you will receive in exchange for your dollar bill is another dollar bill, perhaps less tattered and worn.

Money that is not convertible into anything else-that therefore defines what we mean by “real money”-is called definitive money. This role was once played by god. Today it is played by Fed dollars. You can think of Fed dollars as a sort of “artificial gold”, created by the government. The provision of definitive money is today a normal function of most central banks. Money of this type, which exists by government order or fiat alone, is called fiat money.

In addition to Fed dollars, our definitive money includes some currency issued by the U.S. Treasury, mostly in the form of coins. These coins are token money: their value as metal is well below their face value (the last silver coin was minted for general circulation in 1971). There have been two recent attempts to replace the one-dollar bill with a coin. The Susan B. Anthony dollar was introduced in 1979, and the gold-colored Sacagawea dollar in 1999. However, neither new coin has been a success with the public, which seems to prefer paper.

In May 2001, Federal Reserve notes issued amounted to $565 billion. Deposits at the Federal Reserve Banks amounted to $39 billion. Treasury currency amounted to $27 billion. The total amount of definitive money was the total of these three amounts – $631 billion.