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Paper Money
Paper money, otherwise known as a banknote is a promissory note issued by a central bank of a country. It represented a store of value, backed by the credibility of the issuing authority.
It allows the bearer of the banknote to use it as money, a legal tender; a medium of payment recognized by law for meeting financial obligations.
Other forms of paper money like drafts, letters of credits and privately issued IOU had been used intermittently for centuries.
Along with coins, paper money is a common form of legal tender in most countries today. While low valued base metal coins are used as lower monetary denomination, banknotes are usually used as a higher value unit.
Advantages and Disadvantages
There are advantages of using paper currency but also disadvantages.
The advantage of using paper currency reduced the need to transport large amounts of gold and silver as payment, thus reducing risk. Paper currency is readily accepted, easily transported, exchanged or divided to be used in different transactions.
Banknotes are usually printed on paper or polymer. They are easier to produce than coins and have a much lower cost of issue to coins with the same value.
The main disadvantage of paper money is that it has no intrinsic value by itself, unlike gold or silver. Because banknotes can be easily created by a printing press, there is nothing to stop the issuing authorities from printing more paper money (creating credit) to fund government activity or to inject liquidity in the banking system, thus creating inflationary pressures resulting in the cost of living and prices to rise.
The Diminishing Value of Paper Money
The perception of banknotes as money has evolved rather rapidly, in the last 100 years or so. Originally, the issue of paper money was linked to the security and backing of precious metals like gold and silver.
Unfortunately, the British and many other European countries sever their currency link to the gold standard during the First World War and the Great Depression in the late 1920s to early 1930s.
After the Second World War, the US Dollar replaced the British Pound Sterling as the reserve currency of the world as it was the only currency still linked to the gold standard.
However, President Richard Nixon took a series of tough economic measures in 1971 which included unilaterally cancelling the direct convertibility of the US Dollar to gold, effectively ending the Bretton Woods System of international financial exchange.
Nixon’s decision was made without approval from the US Congress and without consultation with members of international monetary system. The international community informally and aptly named this event as the Nixon Shock.
With this subtle but significant change, the US Dollar started losing its value as it is no longer linked to gold.
According to some financial analysts, the US Dollar has lost over 90% of its value since 1971, compounded by the recent Quantitative Easing policies (QE1 & QE2) by the Federal Reserve in response to the global credit crisis in 2007.
Today, all national currencies are known as fiat money. The term derives from the Latin fiat, simply meaning “Let it be done”. The only reason why fiat money has any value is because of government regulation, guarantee to repay, decree or law.
You can find out more about the history of Paper Money here
There are 5 main transitions in the evolution of money (click to read more):
