Free-banking and financial stability in Peru

The theory of free banking establishes that free competition in note issue decreases the probability of financial instability and currency depreciation. This article analyzes the Peruvian experience between 1862 and 1878 and shows that, consistent with the theory, free banking did not lead to financial instability. On the contrary, government intervention in the banking sector contributed to the expansion of paper money and to the decline in the ability of banks to face the demand for specie.