Why do paper currencies carried in people's pockets hold value? Some experts say that banknotes derive their value because the government or central bank that issues them declares so, while others argue that their value stems from people's willingness to accept them as a means of payment.
In this report, "Business Insider" seeks to identify the reasons that give banknotes their purchasing power, explaining the stages of their evolution and their close relationship with gold.
Demand for goods arises from the need for the benefits they contain; for example, people demand food because of its value in nourishing the body and sustaining life.
As for paper money, people demand it not for its intrinsic benefit but to "exchange" it for other goods and services. Money is not beneficial in itself but possesses value as a medium of exchange.
People demand paper notes because of the "purchasing power" and specifically their "price."
Saying that the value of banknotes comes from the government that issues them or from social custom does not provide a complete answer. Some experts argue that money holds value simply because it is "accepted."
For a note to be accepted as "currency," it must have purchasing power. But how does paper designated by the government as "money" attain such purchasing power or price?
The law of supply and demand explains the price of goods and some experts say the same law applies to the price of banknotes.
Paper money was not money in its inception but merely a "representative" substituting for gold. Many paper certificates were "evidence" of ownership of gold held in banks.
Holders of certificates could convert them into gold at any time, and people found it convenient to use paper certificates to purchase goods and services as long as they were considered "money."
Certificates gained "purchasing power" based on people's view of them as a "substitute" for gold.
Some economic doctrines argue that once a "certificate" or paper note gains purchasing power, it can become money regardless of gold, because demand now exists for it.
Acceptable paper certificates opened the door to fraudulent practices as banks succumbed to the temptation to lend more certificates without gold backing to increase their profits.
In free-market economies, banks printing more cash find that the value of paper currency against goods and services declines rapidly.
To preserve their purchasing power, holders of certificates printed without gold backing seek to convert them into the yellow metal.
However, if all holders of paper currency demand conversion to gold simultaneously, it could lead to the bankruptcy of the bank issuing the paper currency. Hence, banks avoid the risk of bankruptcy by printing notes without gold backing.
Governments can bypass this system by issuing decrees allowing banks not to exchange paper currency for gold.
Once banks are no longer obliged to change currencies into precious metal, they see significant opportunities to profit, encouraging them to continue expanding paper currency issuance.
Uncontrolled expansion in printing paper currencies can lead to a sharp rise in prices of goods and services, potentially collapsing the market economy.
The primary purpose of controlling the supply of paper currencies is to prevent competing banks from excessive issuance of currencies and causing each other's bankruptcy.
This can be achieved by establishing a bank with a monopoly on currency printing, the central bank, which has exclusive authority to print its own certificates (paper currency) to replace certificates issued by other banks in all their forms.
Central bank-issued banknotes derive their purchasing power from the fact that various securities can be exchanged for central bank notes at a specified price.
Currency issued by the central bank is fully backed by the bank and has a historical link to gold, and because of this link, central bank notes have purchasing power.
In the United States, which holds the world's reserve currency, contrary to popular belief, the value of the "dollar" derives from its historical connection to money backed by a commodity, namely gold, not by government decree or social custom.
Non-commodity currency, mandated by governments or so-called mandatory currency used in modern banking systems, does not exist in its literal sense.
What the market has created, based on gold-backed money, forced governments to cancel before leaving us dealing with monetary assets whose value is based on the practices of central banks.