The Evolution Of Money

Money evolved as human society grew more sophisticated and required a more
sophisticated means of transacting business.
The following section describes in very simple terms the evolutionary stages of money--how
it evolved from real money to magic money.
1. Barter: One of the first monetary systems was barter. Barter is simply trading a product
or a service for other products and services. For example, if a farmer had a chicken and
needed shoes, the farmer could trade chickens for shoes. The obvious problem
with barter is that it is slow, tedious, and time-consuming. It is hard to measure relative
values. For example, what if the cobbler did not want a chicken? Or if he did, how many
chickens were his shoes really worth? A faster more efficient means of exchange was
needed, so money evolved.
On a side note, however, if the economy continues to slide downward and money remains
tight, you will see barter increase. One good thing about barter is that it is hard for the
government to tax barter transactions. The tax department does not accept chickens.
2. Commodities: To speed up the process of exchange, groups of people came to agree on
tangible items that represented value. Seashells were some of the first forms of commodity
money. So were stones, colored gems, beads, cattle, goats, gold, and silver. Rather than
trade chickens for the shoes, the chicken farmer might simply give the cobbler six colored
gems for the shoes. The use of commodities sped up the process of exchange. more
business could be done in less time.
Today, gold and silver remain the commodities that are internationally accepted as money.
This is the lesson I learned in Vietnam. Paper money was national, but gold was
international, accepted as money even behind enemy lines.
3. Receipt money: To keep precious metals and gems safe, wealthy people would turn their
gold, silver, and gems over for safekeeping to people they trusted. That person would then
issue the wealthy person a receipt for his or her precious metals and gems. This was the
start of banking.
Receipt money was one of the first financial derivatives. Again, the word derivative means
"derived from something else"--just as orange juice is derived from an orange and an egg is
derived from a chicken. As money evolved from a tangible item of value into a derivative of
value, a receipt, the speed of business increased.
In ancient times, when a merchant traveled across the desert from one market to the next,
he would not carry gold or silver for fear of being robbed along the way. Instead, he carried
with him a receipt for gold, silver, or gems in storage. The receipt was a derivative of
valuables he owned and held in storage. If he purchased products at his faraway

destination, he would then pay for his products with the receipt--a derivative of tangible
value.
The seller would then take the receipt and deposit it in his bank. Rather than transfer gold,
silver, and gems back across the desert to the other bank, the two bankers in the two cities
would simply balance or reconcile the trading accounts between buyer and seller with debits
and credits against receipts. This was the start of the modern-day banking and monetary
system. Once again, money evolved and the speed of business increased. Today, modern
forms of receipt money are known as checks, bank drafts, wire transfers, and debit cards.
The core business of banking was best described by the third Lord Rothschild as "facilitating
the movement of money from point A, where it is, to point B, where it is needed."
4. Fractional reserve receipt money: As wealth increased through trade, bankers' vaults
became filled with precious commodities such as gold, silver and gems. Bankers soon
realized that their customers had little use for the gold, silver, and gems themselves.
Receipts were much more convenient for transacting business. Receipts were much lighter,
safer, and easier to carry. To make more money, bankers transitioned from storing wealth to
lending wealth. When a customer came in wanting to borrow money, the banker simply
issued another receipt with interest. In other words, bankers realized that they did not need
their own money to make money. Bankers began effectively printing money.
With more money in circulation, people felt richer. There was no problem with this expanded
money supply as long as everyone didn't want his or her gold, silver, or gems back at the
same time. In modern terms, economists would say, "The economy grew because the
money supply expanded."
5. Fiat money: When President Nixon severed the U.S. dollar from the gold standard in
1971, the United States no longer needed gold, silver, or gems, or anything else in its vaults
to create money.
Technically, prior to 1971, the U.S. dollar was a derivative of gold. After 1971, the U.S.
dollar became a derivative of debt. Severing the dollar from gold was bank robbery of
ungodly proportions.
Fiat money is simply money backed by government's good and credit. If anyone messes
with the government and central bank's monopoly on money, the government has the
power to put that group or person in jail for fraud and counterfeiting. Fiat money means all
bills payable to the government, such as taxes, must be paid in that nation's currency. You
cannot pay your taxes with chickens.

Etymology
The word "money" is believed to originate from a temple of Hera, located on Capitoline, one of Rome's
seven hills. In the ancient world Hera was often associated with money. The temple of Juno Moneta at
Rome was the place where the mint of Ancient Rome was located. [9] The name "Juno" may derive from
the Etruscan goddess Uni (which means "the one", "unique", "unit", "union", "united") and "Moneta" either
from the Latin word "monere" (remind, warn, or instruct) or the Greek word "moneres" (alone, unique).
In the Western world, a prevalent term for coin-money has been specie, stemming from Latin in specie,
meaning 'in kind'

4 essential functions of Money

Generally, economists have defined four types of functions of money which are as follows:
(i) Medium of exchange
(ii) Measurement of value;
(iii) Standard of deferred payments
(iv) Store of value.
These four functions of money have been summed up in a couplet which says: Money is a matter of
functions four, a medium, a measure, a standard and a store.
(i) Money as a Unit of Value:
Money measures the value of various goods and services which are produced in an economy. In other
words, money works as unit of value or standard of value. In barter economy it was very difficult to
decide as to how much volume of goods should be given in exchange of a given quantity of a
commodity.
Money, by performing the function of common measure of value, has saved the society from this
difficulty. Now the value of various goods and services are expressed in terms of money such as Rs.
10 per metre, Rs. 8/- per kilogram etc. In this way, money works as common measure of value by
expressing exchange value of all goods and services in money in the exchange market. By working as
a unit of value, money has facilitated modern business and trade.
(ii) Medium of Exchange:
Right from the beginning, money has been performing an important function as medium of
exchange in the society. Money facilitates transactions of goods and service as a medium of
exchange. Producers sell their goods to the wholesalers in exchange of money. Wholesalers sell the
same goods to the consumers in exchange of money.

In the same way, all sections of society sell their services in exchange of money and with that buy
goods and services which they need. Money, working as medium of exchange, has eliminated
inconvenience which was faced in barter transactions. However, money can operate as medium of
exchange only when it is generally accepted in that role. Bank money can be treated as money simply
on the basis of their general acceptability for they are highly useful.
(iii) Standard of Deferred Payments:
Modem economic setup is based on credit and credit is paid in the form of money only. In reality the
significance of credit has increased so much that it will not be improper to call it as the foundation
stone of modem economic progress. Money, besides being the basis of current transactions, is also
the basis of deferred payments. Only money is such a commodity in whose form accounts of deferred
payments can be maintained in such a way so that both creditors and debtors do not stand to lose.

(iv) Store of Value:

It was virtually impossible to store surplus value under barter economy; the discovery of money has
removed this difficulty. With the help of money, people can store surplus purchasing power and use
it whenever they want. Saving in money is not only secure but its possibility of being destroyed is
very less. Besides, it can be used whenever need be. By facilitating accumulation of money, money
has become the only basis of promoting capital formation and modern production technique and
corporate business facilitated there from.

Measure of value
Money acts as a standard measure and common denomination of trade. It is thus a basis for quoting and
bargaining of prices. It is necessary for developing efficient accounting systems. But its most important
usage is as a method for comparing the values of dissimilar objects.

Money
Money is any object or record that is generally accepted as payment for goods and services and
repayment of debts in a given socio-economic context or country. The main functions of money are
distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,

a standard of deferred payment. Any kind of object or secure verifiable record that fulfills these functions
can be considered money.
Money is historically an emergent market phenomenon establishing a commodity money, but nearly all
contemporary money systems are based on fiat money.[4] Fiat money, like any check or note of debt, is
without intrinsic use value as a physical commodity. It derives its value by being declared by a
government to be legal tender; that is, it must be accepted as a form of payment within the boundaries of
the country, for "all debts, public and private" [citation needed]. Such laws in practice cause fiat money to acquire
the value of any of the goods and services that it may be traded for within the nation that issues it.
The money supply of a country consists of currency (banknotes and coins) and bank money(the balance
held in checking accounts and savings accounts). Bank money, which consists only of records (mostly
computerized in modern banking), forms by far the largest part of the money supply in developed nations

Types of money
Currently, most modern monetary systems are based on fiat money. However, for most
of history, almost all money was commodity money, such as gold and silver coins. As
economies developed, commodity money was eventually replaced by representative
money, such as the gold standard, as traders found the physical transportation of gold
and silver burdensome. Fiat currencies gradually took over in the last hundred years,
especially since the breakup of the Bretton Woods system in the early 1970s.

Commodity money
Main article: Commodity money

A 1914 British Gold sovereign

Many items have been used as commodity money such as naturally scarce precious
metals, conch shells, barley, beads etc., as well as many other things that are thought
of as having value. Commodity money value comes from the commodity out of which it
is made. The commodity itself constitutes the money, and the money is the commodity.
Examples of commodities that have been used as mediums of exchange
include gold, silver, copper, rice, salt, peppercorns, large stones, decorated belts,
shells, alcohol, cigarettes, cannabis, candy, etc. These items were sometimes used in a
metric of perceived value in conjunction to one another, in various commodity valuation
or Price System economies. Use of commodity money is similar to barter, but a
commodity money provides a simple and automatic unit of account for the commodity
which is being used as money. Although some gold coins such as the Krugerrand are
considered legal tender, there is no record of their face value on either side of the coin.
The rationale for this is that emphasis is laid on their direct link to the prevailing value of
their fine gold content.[26] American Eagles are imprinted with their gold content and
legal tender face value.[27]

Representative money
Main article: Representative money

In 1875, the British economist William Stanley Jevons described the money used at the
time as "representative money". Representative money is money that consists of token
coins, paper money or other physical tokens such as certificates, that can be reliably
exchanged for a fixed quantity of a commodity such as gold or silver. The value of
representative money stands in direct and fixed relation to the commodity that backs it,
while not itself being composed of that commodity.[28]

Fiat money
Main article: Fiat money

Gold coins are an example of legal tender that are traded for their intrinsic value, rather than their
face value.

Fiat money or fiat currency is money whose value is not derived from any intrinsic value
or guarantee that it can be converted into a valuable commodity (such as gold). Instead,
it has value only by government order (fiat). Usually, the government declares the fiat
currency (typically notes and coins from a central bank, such as the Federal Reserve
System in the U.S.) to be legal tender, making it unlawful to not accept the fiat currency
as a means of repayment for all debts, public and private. [29][30]
Some bullion coins such as the Australian Gold Nugget and American Eagle are legal
tender, however, they trade based on the market price of the metal content as
a commodity, rather than their legal tender face value (which is usually only a small
fraction of their bullion value).[27][31]
Fiat money, if physically represented in the form of currency (paper or coins) can be
accidentally damaged or destroyed. However, fiat money has an advantage over
representative or commodity money, in that the same laws that created the money can
also define rules for its replacement in case of damage or destruction. For example, the
U.S. government will replace mutilated Federal Reserve notes (U.S. fiat money) if at
least half of the physical note can be reconstructed, or if it can be otherwise proven to
have been destroyed.[32] By contrast, commodity money which has been lost or
destroyed cannot be recovered.

Coinage
Main article: Coin

These factors led to the shift of the store of value being the metal itself: at first silver,
then both silver and gold, at one point there was bronze as well. Now we have copper
coins and other non-precious metals as coins. Metals were mined, weighed, and
stamped into coins. This was to assure the individual taking the coin that he was getting
a certain known weight of precious metal. Coins could be counterfeited, but they also
created a new unit of account, which helped lead to banking. Archimedes'
principle provided the next link: coins could now be easily tested for their fine weight of

metal, and thus the value of a coin could be determined, even if it had been shaved,
debased or otherwise tampered with (see Numismatics).
In most major economies using coinage, copper, silver and gold formed three tiers of
coins. Gold coins were used for large purchases, payment of the military and backing of
state activities. Silver coins were used for midsized transactions, and as a unit of
account fortaxes, dues, contracts and fealty, while copper coins represented the
coinage of common transaction. This system had been used in ancient India since the
time of the Mahajanapadas. In Europe, this system worked through the medieval period
because there was virtually no new gold, silver or copper introduced through mining or
conquest.[citation needed] Thus the overall ratios of the three coinages remained roughly
equivalent.

Paper money
Main article: Banknote

Huizi currency, issued in 1160

In premodern China, the need for credit and for circulating a medium that was less of a
burden than exchanging thousands of copper coins led to the introduction of paper
money, commonly known today as banknotes. This economic phenomenon was a slow
and gradual process that took place from the late Tang Dynasty (618907) into
the Song Dynasty (9601279). It began as a means for merchants to exchange heavy
coinage for receipts of deposit issued as promissory notes from shops of wholesalers,

notes that were valid for temporary use in a small regional territory. In the 10th century,
the Song Dynasty government began circulating these notes amongst the traders in
theirmonopolized salt industry. The Song government granted several shops the sole
right to issue banknotes, and in the early 12th century the government finally took over
these shops to produce state-issued currency. Yet the banknotes issued were still
regionally valid and temporary; it was not until the mid 13th century that a standard and
uniform government issue of paper money was made into an acceptable nationwide
currency. The already widespread methods of woodblock printing and then Pi
Sheng's movable type printing by the 11th century was the impetus for the massive
production of paper money in premodern China.
At around the same time in the medieval Islamic world, a vigorous monetary
economy was created during the 7th12th centuries on the basis of the expanding
levels of circulation of a stable high-value currency (the dinar). Innovations introduced
by Muslim economists, traders and merchants include the earliest uses of credit,
[33]
cheques, promissory notes,[34] savings accounts, transactional
accounts, loaning, trusts, exchange rates, the transfer of credit anddebt,[35] and banking
institutions for loans and deposits.[35]
In Europe, paper money was first introduced in Sweden in 1661. Sweden was rich in
copper, thus, because of copper's low value, extraordinarily big coins (often weighing
several kilograms) had to be made. The advantages of paper currency were numerous:
it reduced transport of gold and silver, and thus lowered the risks; it made loaning gold
or silver at interest easier, since the specie (gold or silver) never left the possession of
the lender until someone else redeemed the note; and it allowed for a division of
currency into credit and specie backed forms. It enabled the sale of stock in joint stock
companies, and the redemption of those shares in paper.
However, these advantages held within them disadvantages. First, since a note has no
intrinsic value, there was nothing to stop issuing authorities from printing more of it than
they had specie to back it with. Second, because it increased the money supply, it
increased inflationary pressures, a fact observed by David Hume in the 18th century.
The result is that paper money would often lead to an inflationary bubble, which could
collapse if people began demanding hard money, causing the demand for paper notes
to fall to zero. The printing of paper money was also associated with wars, and financing
of wars, and therefore regarded as part of maintaining astanding army. For these

reasons, paper currency was held in suspicion and hostility in Europe and America. It
was also addictive, since the speculative profits of trade and capital creation were quite
large. Major nations established mints to print money and mint coins, and branches of
their treasury to collect taxes and hold gold and silver stock.
At this time both silver and gold were considered legal tender, and accepted by
governments for taxes. However, the instability in the ratio between the two grew over
the course of the 19th century, with the increase both in supply of these metals,
particularly silver, and of trade. This is called bimetallism and the attempt to create
a bimetallic standard where both gold and silver backed currency remained in
circulation occupied the efforts of inflationists. Governments at this point could use
currency as an instrument of policy, printing paper currency such as the United
States Greenback, to pay for military expenditures. They could also set the terms at
which they would redeem notes for specie, by limiting the amount of purchase, or the
minimum amount that could be redeemed.

Banknotes with a face value of 5000 of different currencies

By 1900, most of the industrializing nations were on some form of gold standard, with
paper notes and silver coins constituting the circulating medium. Private banks and
governments across the world followed Gresham's Law: keeping gold and silver paid,
but paying out in notes. This did not happen all around the world at the same time, but
occurred sporadically, generally in times of war or financial crisis, beginning in the early

part of the 20th century and continuing across the world until the late 20th century, when
the regime of floating fiat currencies came into force. One of the last countries to break
away from the gold standard was the United States in 1971.
No country anywhere in the world today has an enforceable gold standard or silver
standard currency system.

Commercial bank money

Main article: Demand deposit

Demand deposit in cheque form

Commercial bank money or demand deposits are claims against financial institutions
that can be used for the purchase of goods and services. A demand deposit account is
an account from which funds can be withdrawn at any time by check or cash withdrawal
without giving the bank or financial institution any prior notice. Banks have the legal
obligation to return funds held in demand deposits immediately upon demand (or 'at
call'). Demand deposit withdrawals can be performed in person, via checks or bank
drafts, using automatic teller machines (ATMs), or through online banking.[36]
Commercial bank money is created through fractional-reserve banking, the banking
practice where banks keep only a fraction of their deposits in reserve (as cash and other
highly liquid assets) and lend out the remainder, while maintaining the simultaneous
obligation to redeem all these deposits upon demand. [37][38] Commercial bank money
differs from commodity and fiat money in two ways, firstly it is non-physical, as its
existence is only reflected in the account ledgers of banks and other financial
institutions, and secondly, there is some element of risk that the claim will not be fulfilled
if the financial institution becomes insolvent. The process of fractional-reserve banking
has a cumulative effect of money creation by commercial banks, as it expands money

supply (cash and demand deposits) beyond what it would otherwise be. Because of the
prevalence of fractional reserve banking, the broad money supply of most countries is a
multiple larger than the amount of base moneycreated by the country's central bank.
That multiple (called the money multiplier) is determined by the reserve requirement or
otherfinancial ratio requirements imposed by financial regulators.
The money supply of a country is usually held to be the total amount of currency in
circulation plus the total amount of checking and savings deposits in the commercial
banks in the country. In modern economies, relatively little of the money supply is in
physical currency. For example, in December 2010 in the U.S., of the $8853.4 billion in
broad money supply (M2), only $915.7 billion (about 10%) consisted of physical coins
and paper money.

Digital money
Digital currencies gained momentum in before the 2000 tech bubble. Flooz and Beenz were particularly
advertised as an alternative form of money. While the tech bubble caused them to be short lived, many
new digital currencies (such as bitcoin) have reached some, albeit generally small userbases.

Monetary policy
The control of the amount of money in the economy is known as monetary policy. Monetary policy is the
process by which a government, central bank, or monetary authority manages the money supply to
achieve specific goals. Usually the goal of monetary policy is to accommodate economic growth in an
environment of stable prices. Modern day monetary systems are based on fiat money and are no longer
tied to the value of gold. A failed monetary policy can have significant detrimental effects on an economy
and the society that depends on it. These includehyperinflation, stagflation, recession,
high unemployment, shortages of imported goods, inability to export goods, and even total monetary
collapse and the adoption of a much less efficient barter economy

Governments and central banks have taken both regulatory and free
market approaches to monetary policy. Some of the tools used to control the money
supply include:

changing the interest rate at which the central bank loans money to (or borrows
money from) the commercial banks

currency purchases or sales

increasing or lowering government borrowing

increasing or lowering government spending

manipulation of exchange rates

raising or lowering bank reserve requirements

regulation or prohibition of private currencies

taxation or tax breaks on imports or exports of capital into a country

Market liquidity
Main article: Market liquidity
Market liquidity describes how easily an item can be traded for another item, or into the common currency
within an economy. Money is the most liquid asset because it is universally recognised and accepted as
the common currency. In this way, money gives consumers the freedom to trade goods and services
easily without having to barter.
Liquid financial instruments are easily tradable and have low transaction costs. There should be no (or
minimal) spread between the prices to buy and sell the instrument being used as money.

Methods of Note Issue

Both the principles of, note issue mentioned above, have serious defects. The monetary experts by
coordinating the advantages of both the principles have evolved various systems or methods of
notes issue. The main systems of note issue prevalent in different countries of the world are (1)
Partial Fiduciary System. (2) Proportional Reserve System. (3) Minimum Reserve System. These
systems are now discussed in brief.
(1) Fixed Fiduciary System. Under this system, a fixed amount is laid down by law which need to
be covered by government securities. Notes issued in excess of this amount must be fully backed by
gold. England adopted this system in 1844. The system lacked elasticity and was not capable of
satisfying the needs of trade and industry. This system was abandoned in 1913 in favour of
proportional reserve system.
(2) Proportional Reserve System. Under this system, the central bank is to keep a certain
percentage of the total notes issued in gold. The r is to be covered by sound government securities,
trade bills etc. This system remained prevalent in USA, Great Britain and over a large part of the
world. The proportional reserve system was also adopted by State Bank of Pakistan (SBP) and it
remained enforced till December 1965. This system was abandoned in 1965 as it was rigid and
lacked elasticity. The State Bank of Pakistan could not give guarantee for full convertibility of notes.
The State Bank of Pakistan has now adopted a new system of note issue named as Minimum
Reserve System.

(3) Minimum Reserve System. The proportional reserve system of note issue has been replaced
by minimum reserve system in Pakistan in 1965. According to this system, the central bank is
required to keep only a minimum amount of reserve in the form of gold and foreign exchange
securities. The central bank can expand note issue in accordance with the volume of business
activities without backing of gold. The level of currency backing by gold is fixed at Rs. 1200 million in
Pakistan. The merit of this system is that it ensures an adequate supply of currency to meet the
business demands of the country. In other words, the method of note issue is sufficiently elastic. The
demerit is that paper currency issued is practically inconvertible in this system.

Types of Paper Money

The money made of paper is called paper money. It consists of currency notes issued by the
government or the central bank of a country. In India, one rupee notes are issued by the Ministry of
Finance of the Government of India, and all other currency notes of higher denominations are issued
by the Reserve Bank of India.
Paper money is of four types:
(1) Representative paper money,
(2) Convertible paper money,
(3) Inconvertible paper money, and
(4) Fiat money.

1. Representative Paper Money.

Representative paper money is fully backed by gold and silver reserves. Under the monetary system
of representative money, gold and silver equal to the value of paper currency issued are kept hi the
reserves by the monetary authority.
The main advantages of representative paper money are :
(a) It economizes the use of precious metals. These metals are kept hi the reserves,
(b) There is no fear of over- issue of representative money since paper money is fully backed by
metallic reserves,
(c) It inspires public confidence because the public can get the paper money converted into gold as
and when needed.

However, the representative paper money has certain disadvantages:

(a) Since gold and silver reserves are to be maintained, these metals cannot be put to other uses,
(b) Representative paper money system lacks elasticity because under this system money supply
cannot be increased unless equivalent amount of metallic reserves are kept,
(c) It is not suitable for the poor nations which have deficiency of gold and silver.

2. Convertible Paper Money:

The paper money which is convertible into standard coins is called convertible paper money.
The main characteristics of convertible paper money are:
(a) The individuals can get their paper money converted into cash,
(b) The paper money is backed by gold and silver reserves. But, on the assumption that all the
currency notes are not simultaneously presented by the public for encashment, the value of metallic
reserves is less than the value of the notes issued,
(c) The reserves comprise of (i) metallic portion containing gold, silver and standard coins, and (ii)
fiduciary portion containing approved securities.
(d) Generally, the public gets gold and silver in exchange for paper money for making foreign
payments.
The main advantages of the convertible paper money are:
(a) It economises the use of valuable metals.
(b) It is flexible because money supply can be increased without maintaining cent per cent metallic
reserves.
(c) It inspires public confidence because paper money is convertible into standard coins,
(d) It facilitates foreign trade because paper money is converted into gold and silver to make foreign
payments.
The disadvantages of the convertible paper money are:
(a) Since the paper currency under this system is not cent per cent backed by gold and silver, there is
a fear of over-issue of money supply and the resultant danger of inflation,

(b) The convertible paper money does not inspire as much public confidence as the representative
paper money.

3. Inconvertible Paper Money:

The paper money which is not convertible into standard coins or valuable metals is called
inconvertible paper money. Under the system of inconvertible paper money, the monetary authority
maintains no metallic reserves against paper currency. It also gives no guarantee to convert the
paper currency into gold and silver.
The merits of inconvertible paper money are as follows:
(a) Such a paper currency system economises the use of valuable metals,
(b) It is also elastic in the sense that the monetary authority can change money supply according to
the needs of the economy without keeping proportionate metallic reserves.
The in-convertible paper money also has the following demerits:
(a) The danger of paper currency, leading to inflation, always exists in this system,
(b) It inspires less public confidence than a system of representative paper money.

4. Fiat money
Fiat money is only a variety of inconvertible paper money. Fiat money is backed neither by the
metallic nor the fiduciary reserves. In other words, the monetary authority gives no guarantee to
convert fiat money into valuable metals. According to Keynes, Fiat money is Representative (or,
Token) Money (i.e., something the intrinsic value of the material substance of which is divorced from
its monetary face value) now generally made of paper except in the case of small denominations which is created and issued by the State, but is not convertible by law into anything other than itself
and has no fixed value in terms of an objective standard.
The main characteristics of the flat money are:
(a) It has significantly less intrinsic value than its face value,
(b) It is not convertible into any valuable asset,
(c) It is accepted in transactions at face value because it is unlimited legal tender.
Initially, fiat money was used during the period of war or emergency. But, now, it has become a
common phenomenon in most of the countries of the world. Fiat money is particularly useful for
underdeveloped countries which generally lack financial resources for economic development. Fiat

money removes this deficiency and promotes economic development by providing sufficient
resources to the government.
However, fiat money also has certain demerits:
(a) The danger of over-issue of fiat money (or inflation) is always present in a system of fiat money,
(b) It lacks public confidence as it is not backed by metallic reserves,
(c) Foreign exchange rates are liable to wide fluctuations under fiat money system because fiat
money is not linked with other country's money through gold.

Credit Money
In modem economies, with the development of banking activity, credit money is being widely used.
Demand deposits of banks, which are withdraw able through cheques, serve as money and the
cheques are accepted as a means of payments. It is to be noted that a cheque by itself is not money; it
is only a credit instrument which performs the functions of money. That is why credit money is
regarded as near money.
In a modern economy, currency money (paper money and coins) and bank money constitute the
major portion of money supply. As the economy becomes more and more advanced, the proportion
of bank money in the total money supply increases. The currency money is a legal tender and is
generally accepted. While bank deposits are conventional money and lack general acceptability.

PRINCIPLES OF NOTE ISSUE :There are two principles of note issue. First is the currency principle and the second is banking principle.
There are different views about these principles. One school of thought says that there should be full
convertibility of notes into gold bullion. The second gives importance to the elasticity of supply. Now we
discuss these two principle.
CURRENCY PRINCIPLE :The lover of this principle say that paper money is better than the metallic money but there should be
100% backing of gold reserves. They say that in order to maintain the prestige of paper money gold
should be available for the conversion of notes when presented.
ADVANTAGES :i. Safety And Security :The advantage of this system is that it gives full safety and security to the paper currency.
ii. No Danger Of Over Issue :There is no danger of over issue of the currency. So it is an effective check on inflation.
DISADVANTAGES :-

i. Inelastic :The disadvantage of this principle is that it makes the supply of money inelastic. According to this
principle paper currency can only be printed and issued if there is a 100% gold cover available against it.
So this system can not meet the requirement of trade and industry.
ii. Lock Up Of Gold :A huge amount of gold is unnecessarily locked up which can be used in other productive projects.

BANKING PRINCIPLE :According to this principle there is no need of reserve requirements of gold and silver for the notes issued.
The banks are authorized to regulate the note issue keeping in view the need of the business in the
country. The banks themselves will maintain adequate reserves of gold for meeting their obligations of
note. If there is an over issue of notes, the excess money will be automatically presented for cash
payment and proper ratio will be maintained between the supply of money and the gold reserves.

MERITS AND DEMERITS OF ELASTIC SYSTEM :The merit of this principle is that it secures elasticity in the issue of currency.
Not Safe :The demerits of this principle is that it is not a safe. In the history of England banking, many times over
issuance of money created problems for the economy.
Conclusion :After discussing both the principles we can say that both are defective. For a sound system of not issue
security and elasticity must go side by side. Keeping in view the above defects modern world have
devised new methods of regulating note issue.

METHODS OF NOTE ISSUE :Fixed Fiduciary System :Under this system the central bank of the country is permitted to issue bank notes of a given amount
without giving gold and silver cover. The fixed quantity of notes allowed by law to be issued is to be
backed by Govt. securities only. This is named the fiduciary limit. The amounts of notes circulated in
excess of the fiduciary limit must be 100% backed by gold.
ADVANTAGES :1. Elastic System :The first advantage of this system is that it makes the supply of money elastic.
2. Safety :It also gives maximum safety because notes can not be issued in excess of the fiduciary limit unless they
are 100% covered by gold.
3. Check On Inflation :The inflation can be effectively checked.
DISADVANTAGES :-

1. High Fiduciary Limit :If fiduciary limit is high or it has been increased with the passage of time then people will loose confidence
in the currency.
COUNTRIES :1. Great Britain is considered the home of this system of note issue and it has successfully survived since
1844.
2. Japan and Norway are also practicing this system of note issue even today.

PROPORTIONAL RESERVE SYSTEM or PERCENTAGE SYSTEM :According to this system the central bank is required by law to keep a fixed percentage varying from 25 to
40 percent against the note issue. The essential feature of this system is the provision of proportional
metallic reserves against the notes in circulation. The reserve ratio may be allowed to drop below the
legal minimum.
COUNTRIES :1. It was adopted by France and reserve ratio was 30%.
2. Germany adopted it keeping 40% of gold against the note issue.
3. The federal reserve Bank of U.S.A has also adopted it with slight modification.
ADVANTAGE AND DISADVANTAGE :1. Elastic System :The main advantage of this system is that it makes the supply of money elastic.
2. Lock Up Of Gold :The defect with this system is that it locks up the gold reserves unnecessarily. So we cannot use it for
other purpose.
3. Exchange Management or Modified Proportional Reserve System :J.M. Keynes has suggested modified form of proportional reserve system and calls it exchange
management. According to this system the central bank is required by law to keep the percentage
required against the note issue in the form of gold, foreign bills or cash at some foreign banks where gold
standard prevails.
COUNTRIES FOLLOWED :This method is followed in India, Pakistan and in many European Countries. The state bank of Pakistan
has to keep 30% of gold silver or approved foreign exchange against the note issue. This method of note
issue economies the use of gold and also makes the currency system elastic.