Origin of Paper Currency!

Money is one of the supreme power in the world. Each country in the world has its own currency denominations and it is mostly applicable only in that country. Basically, money is not a valuable thing that can be used anywhere. It just acts as an intermediate source for the exchange of goods. But how exchanging of valuable goods is done for a small rectangular piece of paper? Let’s dig in.

Barter system

At the beginning of centuries, trading was happening between goods. This means, if one man gives one good, then the other man gives another good as in exchange. That’s where trade happens. This system is called the Barter System. For example, let’s say there were two people, who want to trade. One person has some vegetables and one person has some fruits. The person who wants some vegetables gives his fruits and gets the vegetables to make the trade complete. But there is a major disadvantage in this system, which happens when the person giving vegetables doesn’t want fruits and he wants shirts. Let’s say there is no availability of shirts in that area. So no trade happens over there. Also, there is another disadvantage in the system, which says the value of goods is exchanged improperly. For example, let’s take the above trade. The person, who is selling fruits in exchange for vegetables, has a lower value than the fruits; which means, that the fruits have a higher value than the vegetables. So there will be some loss to the person who is selling fruits.

Barter system

To solve these disadvantages, a third medium was introduced into the system. This third medium is called “Money”. But paper currency doesn’t really come into action at this time. The difference between money and currency is that money holds a specific value in it, even though it is used as an intermediary source, which we term commodity money. But currency (a rectangular piece of paper) does not hold a specific value to it. . It changes its value, regarding to the economic condition of the country. If a third medium was used, then it is considered as equal to the other medium, and it can be used to buy any goods at any instant. If there is a medium, that is considered as this valuable and used for exchange for goods, it should have certain characteristics; like, it should be demandable, durable, not easy to counterfeit, and not easily procurable. Many materials were chosen as money for the exchange of goods, such as cattle, beverages, metal weapons, and even stones. There is evidence on the island of Yap, where a large doughnut-shaped stone has been used as a medium to exchange goods still now.

Credit (Rai): By Yusuke Kawasaki - Flickr: Rai stone / 石貨, CC BY 2.0, https://commons.wikimedia.org/w/index.php?curid=15254713

But as time goes, precious metals like gold, silver, and other materials were used as an exchange medium. These metals also have a special value over them. Any exchange of medium is done by piles of gold coins. But when exchanging a huge amount of gold, it would be too risky to transport and exchange. So a medium in change to the huge amounts of gold was introduced. This system was first introduced in China in 806 AD. The Chinese capital collected all the people’s gold and started to print promissory notes (I.O.U- I Owe You). It is a type of paper that was given to the customers in exchange for their gold. These notes can be later exchanged with the capital for the gold they stored. Let’s see an example in which promissory notes play an important role.

Let’s say a merchant who wants to trade his goods with another person in another country. When the merchant arrives in the neighboring country, he sells his goods to the person. The person, who is buying the goods, gives promissory notes to the merchant instead of the huge piles of gold, which would be too risky to transport. The merchant by getting the promissory notes travels to his home country and gives the notes to the home bank. The bank in the hometown collects the promissory notes and sends them to the buyer’s hometown. Now the bank in the buyer’s hometown collects the gold from the buyer. This is how the promissory notes play an important role.

The function of Promissory notes (I.O.U)

The banks play a pivotal role in the money exchange. As banks are very useful in exchanging promissory notes, people started to use banks more. Then banks started to issue promissory notes thereby inviting people to deposit their gold in the banks. Thus the official paper currency was born. People started to transact these banknotes without exchanging their gold in the bank. Thus the liquidity of the paper currency increased. So banks made a pivotal role in issuing the IOU. As time passes, only a single bank (called the central bank) was able to print money to eliminate the different banknotes in the hometown itself.

One more huge step that bank made in the financial system is the Fractional Reserve Banking system. It is the type of system which makes the deposit and borrowing of money easier with the bank. Let’s see the process with an example. Let’s say a depositor, deposits a sum of gold and gets the IOU to purchase his own goods, for an easy transaction. Now as the banknotes are circulated over and over by the people without taking the gold coins, the gold coins were used to lend to someone who needs it. This is the basics of Fractional Reserve Banking. In modern banking, this lending is considered a loan. So in modern banking, when we deposit some cash over the bank, the bank makes some money as a reserve and lends extra money as a loan to some other person. This lending creates the cash flow in the economy, where people use it as a third medium to exchange goods and services. Due to Fractional Reserve Banking, the printed currency is no longer dependent upon any gold or silver but it is still backed up by gold. So, if some persons come in to exchange their IOU with gold, the bank will give the money. But if all of them came suddenly, there would be a serious problem, because IOUs were provided beyond the limit of the gold in the vault.

Fractional Reserve Banking

Another important thing that needs to be considered in trading is the gold standard (Exchange rates). As we saw in the disadvantages of the Barter system, that the third medium of exchange was not available and the price of the goods is not balanced well. But in the next period, GOLD came and solved those two problems. But as gold is limited and importable, paper currency was issued to solve the portable problem. But in exchange, goods are always exported to other countries at maximum. So when exposed to international standards, the normally printed currency will be different from other countries. So their currency standard will be different from ours. For example, they use 2 IOUs to buy a basket of apples, whereas we use 1 IOU to buy a basket of apples. This will be similar to every good. We cannot trade based on the apple count because it may be easily procurable in one country and not in another country. So these currencies are backed up to the gold standard and not by the gold limit. For example, let’s say that they purchase 1 ounce of gold using 2 IOUs, and we use 1 IOU to purchase 1ounce of gold. So if both countries followed the gold standard rather than backed up by original gold, international trade can happen.

Gold Standard

During the end of the 20^th century, two major world wars struck the world. These wars were financed by the US, in exchange for gold in their country. So gold standard was only maintained in America. But for trading, the gold standard is important for everyone. So, all the currencies in the world were backed up to the US dollar, as it only maintains the gold standard. Thus any transactions made were done by the US dollar standard. So every country should have some dollars in reserve. That’s why the US dollar is marked as a reserved currency. But even though the gold from the US was taken back by many countries, the world maintained its backup with the US Dollar. Thus by removing the gold standard from the US Dollar in 1971, the paper currencies were termed as fiat currencies, which means not backed by anything like gold or gold standard. And the circulation of currency in the country purely depends upon the continuous monitoring of the economy. If there is too much-printed money, there will be a huge inflation, and if there is less printed money there will be deflation. Both suffer the economic growth of a country. We can see the economic growth of a country by considering the inflation and deflation problems in the next article. Please visit the following link,

https://sciencetopic03.blogspot.com/2021/11/contribution-of-different-factors-to.html

To know how money is created in the economy, please visit the following links,

How money creation is done in the economy? (PART-1- Commercial Banks)

How money creation is done in the economy? (PART-2- Open Market Operation)