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.
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.