Throughout modern history governments have tried to promote the general acceptance of their unbacked paper currencies. One of the most common devices has been legal tender laws that have assured the acceptance of these currencies as tax payments. Economic theory has largely ignored this mechanism, except for the static models of Ross Starr (Econometrica 1974, Economic Theory 2003. I provide the first dynamic model of this mechanism, thus showing explicitly the medium of exchange role of money, accounting for expectations about the government's survival, and enabling more realistic taxation systems. I show that whether competing with other paper moneys, commodity moneys, or checks, a stable government can promote its currency by refusing to accept the other objects in tax payments. While this mechanism has similarities to convertibility, it differs from it on a critical aspect: With this mechanism the government can often keep its favorite money in circulation even while increasing its quantity and thus causing it to decrease in value. This opens the door for a successful inflationary policy.
Modern currency originates in the inconvertible, legal tender paper money that Massachusetts devised in 1690. The circumstances that led to its creation are more complex than the typical story of wartime specie shortage. Due to temporary political constraints of that turbulent period, the currency could be neither backed by land nor imposed on anyone, as was then standard. Instead, it had to be disguised from England as a simple, private-seeming IOU. By pleasing both its pay-demanding troops and England, the government maximized its probability of survival subject to the constraints.
“Monetary innovation, the development of new forms of money, has not received much systematic study from economic historians.”1
In 1686 the leadership of Massachusetts became involved in the first operational bank scheme in America. In 1688 this note-issuing bank was mysteriously aborted at an advanced stage. I suggest a new, simple explanation for the bank's demise. The bank's notes were supposed to be backed mostly by private land in Massachusetts, but a new royal governor invalidated all the land titles. This episode demonstrates the importance of clearly defined and enforced property rights for the development of financial institutions.“After showing him an Indian deed for land, he said that their hand was no more worth than a scratch with a bear's paw, undervaluing all my titles, though everyway legal under our former charter government.”1Joseph Lynde
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