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A simple example may explain what Free Banking is all about. Suppose gold is money, and there is no central bank.

Fred starts a new company, the Bank of Landville. Fred does not bother to buy gold, since he uses his limited funds to buy capital goods such as the building, desks, computers, and vaults.

The first three customers are Harry, Dan, and Bryan. Harry deposits $1000 of gold coins. Dan and Bryan each deposit $1000 of Bank of America banknotes. They sign a contract agreeing that the bank may lend out more funds than initially deposited.

The bank now has assets of $3000 (not counting the value of its capital goods) and liabilities of $3000. The $1000 worth of gold is not really owned by the bank itself, but jointly by the depositors, any of whom may convert their deposits into gold at any time.

Now Lindy wants to borrow $3000. He wants $1000 in paper notes and $2000 in a bank account. The bank prints the notes and creates the bank account. In effect, it is Harry, Dan, and Bryan loaning Lindy the $3000 they deposited, with the bank as the intermediary. The bank now has $6000 in assets: $1000 gold, $2000 BofA notes, and the $3000 loan to Lindy. The bank also has $6000 in liabilities: $5000 in bank deposit accounts, and $1000 in bank notes issued.

Lindy buys supplies with the $1000 in paper notes. There is a demand to hold the notes for purchases, so the $1000 continue to circulate. Holders know they can always come in to the bank and exchange them either for gold coins or for BofA notes.

Lindy buys a computer system and pays for it with the $2000 check from his account. Bernard, the computer seller, deposits the check into the bank and gets a $2000 account in his name.

If everyone went to the bank and demanded gold, there would not be enough gold. But people are not likely to do this - normally, there is no reason to. In fact, Fred thinks there is too much gold in the vaults. He sells $500 of the coins and buys treasury bills, which pay 5% interest. Why keep gold when he can get interest?

David now wants a loan. He too borrows $3000, and Fred creates an account for him for $3000. David pays Susan the travel agent $3000 for a trip to Australia. Susan deposits the $3000 in the bank, and she now has an account of $3000 and David's account is zero.

Fred deposits the BofA notes into Bank of America for a money market account that pays 5% interest. He can always cash it out for gold or BofA notes.

The bank assets are now $9000: a $3000 loan to David, a $3000 loan to Lindy, $500 gold, $500 treasury bills, and $2000 in the BofA money market fund. The liabilities are a $3000 account of Susan, a $2000 account of Bernard, $1000 in Landville Bank notes, and accounts of $1000 each from Harry, Dan, and Bryan.

During the year, Lindy earned a profit of $1000 from his new business. Out of that profit, he pays $300 in interest to the bank in the form of Landville Bank notes. David also pays $300 in interest. He borrowed for consumption, so he will be consuming $300 less from his wages during the year in order to pay the loan. But he is happy, since he was able to take a trip. David's $300 is also paid in Landville Bank Notes.

Fred now has $625 in interest received, $600 from the loans and $25 in BofA notes from the T-bill. He keeps $225: $125 to pay himself wages, $50 as the normal return on his invested capital goods, and $50 rent for the land. The rest of the interest received, $400, he pays to the depositors. Total deposits are $8000, so the rate of interest paid is $400/8000 or 1/20, 5 percent. Fred spends his $175, the government spends its $50 in rent collected, and the depositors also spend their $400, so the bank notes go back into circulation.

Now Harry comes and wants to convert $100 of his bank account into gold. Harry just wants to test the bank. Fred gives Harry $100 of gold coins and deducts $100 from Harry's account. But Bernard would like to have more spending cash, so he converts $1000 of his account to bank notes. There are now $2000 of Landville bank notes circulating, as the demand to hold money has grown. It is really the depositors who benefit, since they are the ones who will be getting the extra interest. Fred still wants to keep $500 in gold on hand, so he converts $100 of his money-market account with Bank of America for $100 of gold coins.

Dan is nervous about the stability of the bank. Fred offers to buy deposit insurance for Dan. It will cost Dan $50 a year, but Dan will be assured of getting either gold or BofA notes if he wants to withdraw his money and the bank is insolvent. Dan uses his interest income of $50 per year to buy the insurance. Dan could alternatively keep his money in BofA notes, but he likes being able to pay by check.

On it goes. People borrow funds, and the economy can grow, without having to have any more gold, so long as people are confident using the bank notes. The bank does not get rich from owning gold; indeed, Fred wants to keep as little gold as necessary, just enough for redemptions to people like Harry. It doesn't matter to Fred whether depositors want to keep their funds in bank accounts or take them out as banknotes. Both are "inside money," liabilities to the bank. Gold and BofA notes are "outside money" to the Landville Bank. The interest paid does not create any need for more money. The demand for more money comes from extra production, which may or may not come from borrowed funds. Loans for consumption just reduce future consumption.

That's how free banking would work.