Knowledge Series:

Evolution of ‘Paper Money’

May 2009
Overview

- In earlier times, anything ranging from rice to cotton to food products like honey could serve as a
medium of exchange
- Over time, the economies that survived on the barter system or in-kind transactions-system became
lesser 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 evolution
happened continuously over time

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

exchange of goods and services

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What Should An Acceptable ‘Medium Of Exchange’ Be Like?

• 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

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 What is ‘money’?
Money is anything that is generally accepted as payment for goods and services
and repayment of debts. The main uses of money are as a medium of exchange,
a unit of account, and a store of value

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Illustration: The Early Barter System

‘C’ owns a fish-farm

But he wants apples

‘A’ owns lots of apples ‘B’ owns mangoes

But he wants oranges But he wants fish

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Illustration: The Early Barter System (cont’d)

1
Step

‘A’ will have to go to ‘C’ and

exchange some apples for fish

Step
2

‘A’ then goes to ‘B’ and exchanges

fish that he bought from ‘C’, for
those oranges he wanted

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Evolution Of Money: ‘Double Coincidence Of Wants’

- 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, but
‘C’ wanted ‘A’’s goods while ‘B’ needed ‘C’’s produce (and so on), then through a complicated series
of 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 other
person has. ‘A’ solved the issue by indirect exchange - he had to trade with a 3rd party for an item he
did 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 trading
his own goods and services for honey. ‘A’ does this, not because he likes honey, but because he knows
that honey can be more readily traded for what he does want, than what he could obtain by directly
bartering with his own goods and services

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

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 Evolution Of Money: ‘Double Coincidence Of Wants’ (cont’d)

- This sets up a positive feedback loop. Increased use of honey in barter, causes ‘A’ and others to begin
trading their goods and services for honey, not because they like honey, but because they know that
the 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 the
honey and trade for what they do want
- This problem overall is caused by the improbability of the wants, needs or events that cause or
motivate 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 fruit
for 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 to
buy 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 tends
to emerge naturally as some form of commodity money

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

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Evolution Of Money: From Gold To Paper

- In the recent past, gold and silver coins were used as a medium of exchange because they were more
durable 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 being
offered in exchange
- This led to the use of metal coins of gold and silver being issued by the king. All coins carrying the seal
of the king carried assurance of quality and weight and hence were universally accepted as a medium
of exchange
- But with the development of the printing press, this form of currencies evolved into paper currencies
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 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 the
quantity of gold in the existing coins and by using the extra gold for minting more coins

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

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Evolution Of Money: From Gold To Paper (cont’d)

- 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 more
paper currency by reducing the pre fixed amount of gold repayable against each currency. This led to
era of convertible currencies, where you can convert your paper currency at any time with a previously
fixed 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 a
point when the actual gold repayable is almost negligible. They you may 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 they were given an assurance that paper currency would not lose its status as a medium
of exchange
- It was then decided to make paper currency compulsory for all to accept the paper currency as a
medium for exchange. Paper currency became a legal tender, which means that you now had the right
to 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”

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

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Evolution Of Money: From Gold To Paper (cont’d)

- Fiat currencies are worth the paper securities backing them. To print “fiat currency” it is not
compulsory to have the backing of gold, it can be printed simply on the backing of government
securities. So the paper currency you hold 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. But many also criticize the era of fiat currency for the unbridled
increase in money supply

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Recap: Why Move From Barter To ‘Money’

The process of evolution of a commodity into a money is general and universal. It occurs anytime a
large group of people trade goods and services under the conditions of barter. This process can be
broken down into simpler parts:

1. ‘Selection pressure’, the force driving the natural selection process, is the problem of a double
coincidence of wants
2. ‘Selectors’ are the intelligent decision makers trading goods and services via a process of indirect
exchange
3. The selectors, guided only by experience from past transactions, will select from among competing
methods of payment, those commodities that can be most easily traded for other commodities and
services
4. An understanding of the fundamental concepts of money i.e. medium of exchange, measure of value,
and store of value etc is not required at for this process of selection to occur. The selectors are driven
only by their desire to make life easier on themselves more than anything else
5. Increased selection of one commodity as a method of payment will only increase its "preferability" as
a method of payment in the eyes of the selectors. This causes a positive feedback loop to occur,
causing even more selectors to select this commodity as a method of payment
6. The end result of this process is that over time, an entire population of people are now buying and
selling their goods and services in exchange for that single commodity only. By definition, this
commodity is money, whether the selectors are aware of it or not. When a commodity is used as
money, the money is called "commodity money". Among primitive tribes, everything from shells, to
cattle, to cocoa beans have been used as commodity money. Gold and silver were used as commodity
money right up to the beginning of the 20th century

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 Thank You

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