Final answer:
In free banking, the money supply is determined by the lending activities of individual banks through the money multiplier effect, without a central monetary authority.
Step-by-step explanation:
Under free banking, market forces determine the money supply through the activities of multiple competing banks without a central monetary authority. These banks issue their own notes and hold various assets, including gold and government securities, as reserves. When a bank, such as Singleton Bank, provides a loan to a company like Hank's Auto Supply, it creates a deposit in another bank, First National Bank, which can then loan out a portion of these funds, while keeping some in reserve.
This process is regulated by the money multiplier, which dictates the total amount that the banking system can expand the initial loan into more loans and deposits. Essentially, the money supply is expanded when banks loan out their excess reserves, and these new loans are deposited and re-loaned by other banks repeatedly.
In a free banking era, the total money supply is influenced by consumer and business demand for loans, banks' willingness to lend, and the reserve ratios that banks maintain. The interplay of these factors creates a self-regulating monetary system where the money supply adjusts in response to economic needs.