Evolution of Paper Money

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Knowledge Series:Evolution of Paper Money

May 2009


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- In earlier times, anything ranging from rice to cotton to food products like honey could serve as amedium of exchange

- Over time, the economies that survived on the barter system or in-kind transactions-system becamelesser and lesser in number, and slowly and steadily the medium of exchange kept evolving, from day

to day goods like rice and crops, to cattle, to precious metals- Precious metals such as gold and silver then became the commonly used medium of exchange and they

continue to inspire confidence even now, in some form or the other

- Today, we use only paper currencies as money and therefore its interesting to see how this evolutionhappened continuously over time

Overview

A universally accepted medium of exchange is important for carrying out day-to-day

exchange of goods and services


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It should be durable

Should be easily divisible into larger or smaller amounts

Should be comparatively scarce: procuring it should require some effort

Should be "homogeneous: every item of the commodity should be exactly like every other item Should be convenient: it should be easy to carry enough around to make trades for other commodities

Should store value: should have some perceived intrinsic value of its own

What Should An Acceptable Medium Of Exchange Be Like?


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Illustration: The Early Barter System

A owns lots of applesBut he wants oranges

B owns mangoesBut he wants fish

C owns a fish-farmBut he wants apples


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Illustration: The Early Barter System (contd)

A will have to go to C andexchange some apples for fish

A then goes to B and exchangesfish that he bought from C, for

those oranges he wanted

S t e p 1

S t e p 2


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- There was a time when money did not exist. What did exist was barter

- But the barter system had many drawbacks. If A wanted to buy something but B did not have it, butC wanted As goods while B needed Cs produce (and so on), then through a complicated seriesof exchanges over time, everyone could get what they wanted. However, this was dependent on too

many factors and took a lot of time- This sort of problem is prevalent in any society that relies on barter, and is referred to as the problem

of a double coincidence of wants - a situation where 2 people each happen to want what the otherperson has. A solved the issue by indirect exchange - he had to trade with a 3rd party for an item hedid not want, and then trade that item for the product he did want

- This process of indirect exchange can be very inconvenient. In the course of his day to day bartering,A may find one day that people tend to prefer honey in trade over other items. He begins tradinghis own goods and services for honey. A does this, not because he likes honey, but because he knowsthat honey can be more readily traded for what he does want, than what he could obtain by directlybartering with his own goods and services

Evolution Of Money: Double Coincidence Of Wants

Double coincidence of wants essentially is a kind of a transaction cost that imposes severelimitations on economies dominated by barter or other in-kind transactions


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- This sets up a positive feedback loop. Increased use of honey in barter, causes A and others to begintrading their goods and services for honey, not because they like honey, but because they know thatthe honey can be readily traded for what they do want

- This causes even more people still to begin trading and bartering for honey, until finally A's whole

community is bartering and trading, not for what they do want, but for honey. They then take thehoney and trade for what they do want

- This problem overall is caused by the improbability of the wants, needs or events that cause ormotivate a transaction occurring at the same time and the same place

- In-kind transactions have several problems, most notably timing constraints. If you wish to trade fruitfor wheat, you can only do this when the fruit and wheat are both available at the same time and place(and only if someone wishes to trade wheat for fruit). That may be a very brief time, or never

- With money, you can sell your fruit when it is ripe and take the money. You can then use the money tobuy wheat when the wheat harvest comes in. Thus the use of money makes all commodities more liquid

- Because of the severe costs imposed by the coincidence of wants in an in-kind economy, money tendsto emerge naturally as some form of commodity money

In earlier times, anything ranging from rice to cotton to food products like honey could serveas a medium of exchange

Evolution Of Money: Double Coincidence Of Wants (contd)


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- In the recent past, gold and silver coins were used as a medium of exchange because they were moredurable and universally accepted as a medium of exchange. But they also had posed their own set of difficulties. For instance one could never be sure of the purity and the quality of the metal beingoffered in exchange

- This led to the use of metal coins of gold and silver being issued by the king. All coins carrying the sealof the king carried assurance of quality and weight and hence were universally accepted as a mediumof exchange

- But with the development of the printing press, this form of currencies evolved into paper currenciesconvertible into a previously fixed amount of gold at any time on demand. This worked well for both

the people and the king. People were happy because carrying paper currency was more convenient andthe king was happy because it did away with the trouble of minting fresh coins to meet rising demand

- In case of gold coins, gold supply could be increased either by procuring more gold or by lowering thequantity of gold in the existing coins and by using the extra gold for minting more coins

Evolution Of Money: From Gold To Paper

Gold/ Silver coins etc were a natural precursor to the use of paper currency, as the valueprinted on it would be easily convertible to the underlying precious metal


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- The second practice of lowering the quantity of gold for minting more coins is called debasement of currency. In paper currencies, it is far easier to carry out debasement and one can simply print morepaper currency by reducing the pre fixed amount of gold repayable against each currency. This led toera of convertible currencies, where you can convert your paper currency at any time with a previouslyfixed amount of another commodity such as gold

- But as you keep on reducing the pre-fixed amount of gold payable against paper currency, you reach apoint when the actual gold repayable is almost negligible. They you may wonder why you should botherabout keeping a paper currency that can be physically converted into gold. But people wanted to usepaper currency only as a medium of exchange for other goods and services and would not have mindedlosing gold if they were given an assurance that paper currency would not lose its status as a mediumof exchange

- It was then decided to make paper currency compulsory for all to accept the paper currency as amedium for exchange. Paper currency became a legal tender, which means that you now had the rightto offer the paper currency as a settlement of your debts and others are bound to accept the same.This is what led to the birth of fiat currency

Evolution Of Money: From Gold To Paper (contd)

Gold/ Silver coins etc were a natural precursor to the use of paper currency, as the valueprinted on it would be easily convertible to the underlying precious metal


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- Fiat currencies are worth the paper securities backing them. To print fiat currency it is notcompulsory to have the backing of gold, it can be printed simply on the backing of governmentsecurities. So the paper currency you hold loses physical convertibility with gold , however it retainsfinancial convertibility with government securities backing it. So you can convert your money intogovernment securities and vice versa. But many also criticize the era of fiat currency for the unbridledincrease in money supply

Evolution Of Money: From Gold To Paper (contd)


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Thank You

Evolution of Paper Money

Documents

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