IV) Paper money- Like coins, the exact time of introduction of paper money is not precisely known but it was introduced due to scarcity of gold and silver and other disadvantages of metallic money.
Paper money was introduced as a substitute for coins in the national economy stage.
China was the first country in the world to make use of paper currency in the 9th century but its use on a large scale began in the 17th and 18th century. In India, it began in the 19th century.
Paper money is token money and not full-bodied money because its face value is greater than the intrinsic value.
For convenience coins were deposited with reputed merchants known as “shroffs”. In return the depositor received a receipt. The receipts were recognized by all merchants as money. People had confidence in such receipts because their value remained constant over a period of time. Also physical withdrawals were not necessary.
Paper money originally came as paper receipts [deposit receipts] against metallic money by private bankers, shroffs etc (notes). Since it was inconvenient and dangerous to carry gold and silver from one place to another.
The European merchants adopted a practice of carrying paper showing their title to metallic money which they kept with the goldsmith.
At first paper money was only a substitute for metallic money. The currency notes stated “On demand I promise to pay a sum of ———-”. This note was signed by the issuing authority.
In the early stages, receipts of the goldsmiths or currency notes bore a promise to pay on demand a certain quantity. Though this currency had no intrinsic value, it could be fully converted into gold on demand. Therefore it was known as currency fully backed by gold ie representative paper money, convertible token money.
It was realized by the goldsmiths that the entire stock of gold need not be maintained and therefore they used it to make a profit by investing it. Therefore currency with partial backing came into circulation ie partially backed paper currency. Therefore currency notes with partial backing came into circulation, ie partially backed paper money. However, if desired by the depositor, the receipt could be converted into gold and silver. Therefore, this partially backed money was also known as convertible token money.
Gradually notes were issued on a large scale. The Central bank in the country monopolized issuing of currency and minting coins. When paper money contains a promise to pay the holder a certain quantity of legal tender money it is fiduciary money.
The gold standard was abolished in 1930’s after which conversion of token money into gold and silver
was stopped. This money was inconvertible but had the sanction of the law (fiat money) and therefore had general acceptability and people’s confidence.
This money has broken the link with metal money Paper money consists of noted issued by the state treasury or the central bank of a country.
In India we follow a duel system – all the coins and notes of Re1/- are issued by the ministry of finance of the government of India. While all other currency notes of higher denominations ie Rs2, Rs5. Rs10. Rs20.
Rs50. Rs100. Rs500 and Rs1000 are issued by the Reserve Bank of India.
Advantages of paper money-
1) Economical.
2) Convenient.
3) Homogeneous.
4) Easily portable
5)Stable value.
6) Elastic in supply.
7) Cheap remittances.
8) Advantageous to banks (banks can create money against it).
9) Easy to store.
10) Easy to count.
11) Fiscal advantage.
Disadvantages of paper money -
1) Limited life span of paper.
2) Risk of theft.
3) Possibility of damage of paper.
4) Cash transactions [therefore not useful for credit transactions.]
5) No value outside the country.
6) Inconvenient to use in case of large transactions.
7) Danger of over issue.
Classification of paper money
a) Representative paper money.
b) Convertible paper money,
c) Inconvertible paper money.
a) Representative paper money –
In the early stages, receipts of the goldsmiths or currency notes bore a promise to pay on demand a certain quantity. Though this currency had no intrinsic value, it could be fully converted into gold on demand. Therefore it was known as currency fully backed by gold ie representative paper money, convertible token money.
Initially it was this type of representative paper money that was introduced. Representative Full-bodied Money is usually made of paper, is in effect a circulating warehouse receipt for full-bodied coins or their equivalent in bullion.
The representative full-bodied money itself has no significant value as a commodity, but it “represents in circulation an amount of metal with a commodity value equal to the value of the money
The notes could be exchanged for gold and silver on demand. This helped to maintain public confidence in paper currency.
Since paper money performed the function of money, wastage involved in depreciation of metallic coins was avoided
Paper currency notes fully backed by metallic reserves may be described as representative paper money.
For the issue of such notes the monetary authority maintains 100% gold and silver reserves or full bodied coins.
The supply of this money depends on the metallic reserves possessed by the central bank of the country. Therefore such money can be issued to the extent of metallic money available for backing it.
.Now a days paper money is not fully backed by gold and silver and therefore representative paper money is not found anywhere in the world.
b) Convertible paper money-
It was realized by the goldsmiths that the entire stock of gold need not be maintained and therefore they used it to make a profit by investing it. Therefore currency with partial backing came into circulation ie partially backed paper currency. However, if desired by the depositor, the receipt could be converted into gold and silver. Therefore, this partially backed money was also known as convertible token money.
Gradually notes were issued on a large scale.
Therefore if the issuing authority promises to convert currency notes into standard money (coins of gold and silver) on demand it is known as it is known as convertible paper money.
The value of gold and silver kept in reserve is less than the value of notes issued by the monetary authority.
It was based on the fact that people found notes very convenient to use. Hence all of them together will rarely think of presenting them to the issuing authority for encashment. That is why instead of keeping 100% reserves only 30% to 40% of the total amount of notes was kept in gold reserves. This enabled encashment of notes when presented for exchange into gold by some people.
This was partially backed money.
c) Inconvertible paper money/Fiat money -
Gradually notes were issued on a large scale.
The Central bank in the country monopolized issuing of currency and minting coins. When paper money contains a promise to pay the holder a certain quantity of legal tender money it is fiduciary money
The gold standard was abolished in 1930’s after which conversion of token money into gold and silver was stopped. This money was inconvertible but had the sanction of the law and therefore had general acceptability and people’s confidence. This money has broken the link with metal money ie fiat money.
Fiat “a command of the sovereign” This money is backed by legal force ie by enforcement of law. Fiat money is not convertible into standard money on demand Fiat money circulates in the country on the command of the government. Such money is issued by the government and is legal tender money. This money is not entirely backed by metallic reserves. Only a proportional or a minimum reserve is kept and so it is called “money by command” ie by the force of law. No one can refuse to accept this money.
Such money is issued by the government at the time of crises or emergency without the backing of gold and silver. It is also known as emergency money. Fiat money may also result in inflation.
Paper money consists of noted issued by the state treasury or the central bank of a country.
In most parts of the world fiat or inconvertible paper money is the most important form of money today.
When no responsibility is taken by the issuing authority to convert notes into gold and silver on demand it is called inconvertible paper money.
The greatest danger of inconvertible paper money is the possibility of over issue.
Fiat money is not convertible into anything but itself.
Re1/- notes issued by the RBI in India is fiat money because they are not convertible into gold or silver.
According to Paul Samuelson, “Fiat money is accepted because it is accepted”.
Present Indian currency is fiat currency.