How did paper money come to be accepted as a medium of exchange?

How did paper money come to be accepted as a medium of exchange?
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First Published: Sun, Feb 10 2008. 11 39 PM IST
Updated: Sun, Feb 10 2008. 11 39 PM IST
Our friend Jinny thinks that money has been a far more important invention than the wheel. Without money, our life would come to a grinding halt. We need something to serve as a universally accepted medium of exchange for carrying out our day-to-day exchange of goods and services. Precious metals such as gold and silver were among the first to be used as a medium of exchange, and they continue to inspire confidence even now. But today, instead of gold, we use paper currencies as money. It would be interesting to see how money has evolved continuously over time, right from the age of gold coins to the age of “fiat currency”.
Johnny: It is so nice that in our age we don’t have to carry a pair of shoes for exchanging with a dozen eggs. In fact, you need not carry anything except your debit or credit card, which you can use at any time like ready cash. I wonder how this evolution might have taken place over the ages.
Jinny: Well, we talked last week about how people could have started using precious metals such as gold and silver as a medium of exchange because they are more durable and universally accepted as a medium of exchange.
But this was only a first step in the evolution of money. People were more comfortable using precious metals such as gold?as a medium of exchange, but using gold could also have posed its own difficulties. For instance, you could not be very sure about the purity and quality of the metal being offered in exchange. This could have led to the use of metal coins of gold or silver issued by the king. All coins carrying the seal of the king carried the assurance of quality and weight and, hence, were universally accepted as a medium of exchange. But evolution is a continuous process. The development of the printing press could have inspired the king to bring out paper currency convertible 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 and the king was happy because he was spared the trouble of minting fresh coins to meet rising demand. In the case of gold coins, the supply could be increased either by procuring more gold or by lowering the quantity of gold in the existing coins and using the extra gold for minting more coins. The second practice of lowering the quantity of gold in the existing coins is what we call debasement ofcurrency. In paper currencies, it is far easier to carry outdebasement and increase the money supply. The king can simply print more papercurrency by reducing the pre-fixed amount of gold repayable against each currency. This led to an era of convertible currencies, where you can convert your paper currency at any time with the previously fixed amount of some other commodity such as gold. Everything seemed to be on the right track, but the evolution of money did not stop there.
Johnny: After papercurrency, what else followed?
Jinny: The king was running a large government and one day he realized that the gold in his vault was not sufficient to allow him to print more paper currency. When you keep on reducing the pre-fixed amount of gold payable against paper currency, you reach a point when the actual gold repayable is almost negligible. Then you wonder why you should bother about keeping a paper currency that can be physically converted into gold. But people wanted to use paper currency only as a medium of exchange for other goods and services, and would not have minded losing gold if the king could give an assurance that the paper currency would not lose its status as a medium of exchange.
The king, then, came out with a diktat that made it compulsory for all to accept the paper currency as a medium of exchange. Paper currency became legal tender, which means that you have a right to offer the paper currency as a settlement of your debts and others, including the king, are bound to accept the same. This is what led to the birth of “fiat currency”.
To print “fiat currency”, it is not compulsory to have the backing of gold. You can print currency simply on the backing of government securities. Fiat currencies are worth the paper securities backing them. So your paper currency loses physical convertibility with gold; however, it retains financial convertibility with government securities backing it. So you can convert your money into government securities and vice versa. Many criticize the era of fiat currency for the unbridled increase in money supply.
Johnny: Money supply? I always wanted to know what causes the increase and decrease in money supply.
Jinny: I will tell you about that some other time, but let us salute the king who first thought of using paper for writing his promise.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at realsimple@livemint.com
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First Published: Sun, Feb 10 2008. 11 39 PM IST