Paper money, Managerial Economics

Paper Money

Due to the risk of theft, members of the public who owned such metal money would deposit them for safe keeping with goldsmiths and other reliable merchants who would issue a receipt to the depositor.  The metal could not be withdrawn without production of the receipt signed by the depositor.  Each time a transaction was made, the required amount of the metal would be withdrawn and payment made.

It was later discovered that as long as the person being paid was convinced the person paying had gold and the reputation of the goldsmith was sufficient to ensure acceptability of his promise to pay, it became convenient for the depositor to pass on the goldsmith's receipt and the person being paid will withdraw the gold himself.  Initially, the gold would be withdrawn immediately after the transaction was made.  But eventually it was discovered that so long as each time a transaction was made the person being paid was convinced that there was gold, the signed receipt could change hands more than once.  Eventually, the receipts were made payable to the bearer (rather than the depositor) and started to circulate as a means of payment themselves, without the coins having to leave the vaults.  This led to the development of paper money, which had the added advantage of lightness.

Initially, paper money was backed by precious metal and convertible into precious metal on demand.  However, the goldsmiths or early bankers discovered that not all the gold they held was claimed at the same time and that more gold kept on coming in (gold later became the only accepted form of money).  Consequently they started to issue more bank notes than they had gold to back them, and the extra money created was lent out as loans on which interest was charged.  This became lucrative business, so much so that in the 18th and 19th centuries there was a bank crisis in England when the banks failed to honour their obligations to their depositors, i.e. there were more demands than there was gold to meet them.  This caused the government to intervene into the baking system so as to restore confidence.  Initially each bank was allowed to issue its own currency and to issue more currency than it had gold to back it.  This is called fractional backing, but the Bank of England put restrictions on how much money could be issued.

Eventually, the role of issuing currency was completely taken over by the Central Bank for effective control.  Initially, the money issued by the Central Bank was backed by gold (fractionally), i.e. the holder had the right to claim gold from the Central Bank.  However, since money is essentially needed for purchase of goods and services, present day money is not backed by gold, but it is based on the level of production, the higher the output, the higher is the money supply.  Thus, present day money is called TOKEN MONEY i.e. money backed by the level of output.

Posted Date: 11/28/2012 6:52:13 AM | Location : United States







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