Understanding the Bank Note
As a kid, it’s likely that at some point, you tried to amuse yourself by examining a banknote in great detail. The fascinating watermark, the shiny metallic strip, the landscapes on the back – all very interesting subjects.
But if you were a particularly philosophical child, you might have wondered how this piece of paper, fancy as it was, was worth so much. You could just tear it in half in one swift move, and poof, five hundred rupees down the drain. So what gives this fragile scrap of paper its monetary value?
The answer lies in the little statement printed in the center of the note – your curious child self might have noticed this but perhaps failed to understand: “I promise to pay the bearer the sum of five hundred rupees,” signed by the Governor of the RBI.
The paper currency we use today is an example of what is called fiat money – money of a form that has no intrinsic value (like paper), but can be exchanged for value because it is declared as legal tender by the government. This is the purpose fulfilled by the above declaration on our rupee notes. However, this promise used to hold another meaning in the past.
The Promise of Gold
Paper money was introduced in India by the British government in the 1860s, and so our rupee notes were based on the pound notes issued by the Bank of England. In those days, England followed a system known as the gold standard. It linked the value of their currency with gold.
This was first implemented in the form of gold coins, such as the British sovereign, which was a one-pound coin made of about 7 grams of gold. You could say that £1 was worth 7g of gold. Later, as banknotes became prominent, a note could be exchanged for gold instead. This is the origin of the “promise to pay the bearer” – the bank promised to pay you the value of your money in gold or coinage. For instance, in those days, you could walk up to the bank and exchange your £5 note for five gold sovereigns.
Following Britain, many countries adopted the gold standard and it soon became the basis for the international monetary system. For example, India’s rupee was linked to gold through the British pound at a fixed rate of 15 rupees per sovereign.
The key advantage of the gold standard was that it provided stability. The values of currencies were more or less fixed. Governments and banks could not cause price inflation by issuing too much currency. International trade also held more certainty with regard to exchange rates.
Death of the Gold Standard
However, the system worked only in times of peace and prosperity. With the outbreak of World War I, many governments suspended the gold standard in order to finance the war, depleting their gold reserves. Some countries never managed to return to the system. The following Great Depression was the last straw. The masses panicked, rushing to banks to exchange their money for gold and then hoarding it. Gold reserves were severely depleted, and the gold standard came to an end.
Its disadvantages far outweighed the advantages. The necessity for all money to be backed up by gold meant that money supply and economic growth of a country were constrained by the amount of gold production. Monetary policies, such as controlling money supply or interest rates, could not be used to stabilise the economy in times of crisis.
Today, no nation in the world follows the gold standard; it’s been completely replaced by fiat money. Yet gold is still an important financial asset, and central banks continue to hold large gold reserves as a protective measure against economic uncertainty. But if you want to go up to your bank and demand gold in exchange for your 2000-rupee note, you can expect to be escorted out.