A banknote (often known as a bill , paper money or simply a note ) is a kind of negotiable instrument, a promissory note made by a bank payable to the bearer on demand, used as money, and in many jurisdictions is legal tender. Along with coins, banknotes make up the cash or bearer forms of all modern money. With the exception of non-circulating high-value or precious metal commemorative issues, coins are used for lower valued monetary units, while banknotes are used for higher values. However some coins may have a significant value depending on the condition and worth.
Advantages
Originally, precious and semi-precious metals were made into coins and were used to negotiate and settle trades. Banknotes offer an alternative bearer form of money, but the advantages and disadvantages between the two forms of bearer money are complex and so in different circumstances the overall advantage can lie with either form.
The costs of using bearer money include:
- Manufacturing or issue costs. Coins are produced by industrial manufacturing methods that process the precious or semi-precious metals, and require additions of alloy for hardness and wear resistance. By contrast bank notes are printed paper (or polymer), and typically have a lower cost of issue, especially in larger denominations, compared to coin of the same value.
- Wear costs. Coins wear and lose mass over their economic life, and eventually are scrapped. Banknotes do not lose economic value by wear, since, even if they are in poor condition, they are still a legally valid claim on the issuing bank. However, banks of issue do have to pay the cost of replacing banknotes in poor condition and paper notes wear out much faster than coins.
- Opportunity cost of capital. Coins have economic value and are a form of non-financial capital, however they do not pay interest. Banknotes have economic value but are a form of financial capital, a loan to the issuing bank. The issuing bank invests its assets primarily in interest bearing loans and securities, but also needs to hold metallic reserves. Thus banknotes indirectly earn interest through the investments made by the issuing bank, but coins do not pay interest to anyone. This foregone interest is the most important economic advantage of banknotes over coins.
- Cost of transport. Coins can be expensive to transport for high value transactions, but banknotes can be issued in large denominations that are lighter than the equivalent value in coins.
- Cost of acceptance. Coins can be checked for authenticity by weighing and other forms of examination and testing. These costs can be significant, but good quality coin design and manufacturing can help reduce these costs. Banknotes also have an acceptance cost, the costs of checking the banknote's security features and confirming acceptability of the issuing bank.
- Security. Counterfeiting paper notes is easier than forging coins, especially true given the proliferation of color photocopiers and computer image scanners. Numerous banks and nations have incorporated many types of countermeasures in order to keep the money secure.
The different advantages and disadvantages between coins and banknotes imply that there may be an ongoing role for both forms of bearer money, each being used where its advantages outweigh its disadvantages.
Convertibility
The ability to exchange a note for some other kind of value is called "convertibility". For example a US silver certificate was "payable in silver on demand" from the treasury until 1965. If a note is payable on demand for a fixed unit, it is said to be fully convertible to that unit. Limited convertibility occurs when there are restrictions in the time, place, manner or amount of exchange.
A common misconception is that a bank note that is physically inconvertible is necessarily unbacked. Most of the confusion centers around the failure to distinguish between two types of convertibility:
- Physical convertibility, where a unit of currency can be exchanged at the issuing bank for a given physical amount of something, and
- Financial convertibility, where a unit of currency can be exchanged at the issuing bank for a unit's worth of the bank's assets.
The importance of financial convertibility can be seen by imagining that people in a community one day find themselves with more paper currency than they wish to hold — for example, when the main shopping season has ended. If the paper currency is physically convertible (for one ounce of silver, let us suppose), people will return the unwanted paper currency to the bank in exchange for silver, but the bank could head off this demand for silver by selling some of its own bonds to the public in exchange for its own paper currency. For example, if the community has 100 units of unwanted paper money, and if people intend to redeem the unwanted 100 units for silver at the bank, the bank could simply sell 100 units worth of bonds or other assets in exchange for 100 units of its own paper currency. This will soak up the unwanted paper and head off people's desire to redeem the 100 units for silver.
Thus, by conducting this type of open market operation — selling bonds when there is excess currency and buying bonds when there is too little — the bank can maintain the value of the paper currency at one ounce of silver without ever redeeming any paper currency for silver. In fact, this is essentially what all modern central banks do, and the fact that their currencies might be physically inconvertible is made irrelevant by the maintenance of financial convertibility. Note that financial convertibility cannot be maintained unless the bank has sufficient assets to back the currency it has issued. Thus, it is an illusion that any physically inconvertible currency is necessarily also unbacked.
The argument against fiat paper currency is a practical one, with the best example being the US dollar, which has lost 95% of its value since 1913. This should be compared with the period of the Gold Standard, which began in the UK in 1717 and lasted until 1931, when there was essentially no inflation over the period. The entitlement to redeem banknotes in gold (which the bank cannot print) means that if a bank prints more paper money than it has gold in its vaults it runs the risk of a run on the bank, when the only mechanism available to stop the run is to raise interest rates without limit until the note holders stop redeeming their paper.
History
Paper money originated in two forms: drafts, which are receipts for value held on account, and "bills", which were issued with a promise to convert at a later date.
Money is based on the coming to pre-eminence of some commodity as payment. The oldest monetary basis was for agricultural capital: cattle and grain. In Ancient Mesopotamia, drafts were issued against stored grain as a unit of account. A "drachma" was a weight of grain. Japan's feudal system was based on rice per year – koku.
At the same time, legal codes enforced the payment for injury in a standardized form, usually in precious metals. The development of money then comes from the role of agricultural capital and precious metals having a privileged place in the economy.
Such drafts were used for giro systems of banking as early as Ptolemaic Egypt in the first century BC.
The perception of banknotes as money has evolved over time. Originally, money was based on precious metals. Banknotes were seen as essentially an I.O.U. or promissory note: a promise to pay someone in precious metal on presentation (see representative money). With the gradual removal of precious metals from the monetary system, banknotes evolved to represent credit money, or (if backed by the credit of a government) also fiat money.
Notes or bills were often referred to in 18th century novels and were often a key part of the plot such as a "note drawn by Lord X for £100 pounds which becomes due in 3 months time"
First banknotes in the world
The use of paper money as a circulating medium is intimately related to shortages of metal for coins. In ancient China coins were circular with a rectangular hole in the middle. Several coins could be strung together on a rope. Merchants in China, if they became rich enough, found that their strings of coins were too heavy to carry around easily. To solve this problem, coins were often left with a trustworthy person, and the merchant was given a slip of paper recording how much money he had with that person. If he showed the paper to that person he could regain his money. Eventually, the paper money called "jiaozi" originated from these promissory notes.
In the 600s there were local issues of paper currency in China and by 960 the Song Dynasty, short of copper for striking coins, issued the first generally circulating notes. A note is a promise to redeem later for some other object of value, usually specie. The issue of credit notes is often for a limited duration, and at some discount to the promised amount later. The jiaozi nevertheless did not replace coins during the Song Dynasty; paper money was used alongside the coins.
The successive Yuan Dynasty was the first dynasty in China to use paper currency as the predominant circulating medium. The founder of the Yuan Dynasty, Kublai Khan, issued paper money known as Chao in his reign. The original notes during the Yuan Dynasty were restricted in area and duration as in the Song Dynas
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