Paper Money: US

A banknote (more commonly known as a bill in the United States and Canada) is a kind of negotiable instrument, a promissory note made by a bank payable to bearer on demand, used as money, and under many jurisdictions is used as legal tender. more...

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With coins, banknotes make up the cash forms of all modern money. With the exception of non-circulating high-value or precious metal commemorative issues, coins are generally used for lower valued monetary units, while banknotes are used for higher values.

Originally, the value of money was determined by the intrinsic value of the material the money was made of, such as silver or gold. However, carrying around a lot of precious metal was cumbersome and often dangerous. As an alternative, banknotes would be issued. In financial terms, a note is a promise to pay someone money. Banknotes were originally a promise to pay the bearer an amount of precious metal stored in a vault somewhere. In this way the stored value (usually in gold or silver coins) backing the banknote could transfer ownership in exchange for goods or services.

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 in 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 inconvertible is necessarily unbacked (so-called "fiat money"). Most of the confusion centers around the failure to distinguish between two types of convertibility: 1) Physical convertibility, where a unit of currency (a dollar) can be exchanged at the issuing bank for a given physical amount of something, and 2) Financial convertibility, where a dollar can be exchanged at the issuing bank for a dollar'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 Christmas shopping season has ended. If the dollar is physically convertible (for one ounce of silver, let us suppose), people will return the unwanted dollars 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 dollars. For example, if the community has $100 of unwanted paper money, and if people intend to redeem the unwanted $100 for silver at the bank, the bank could simply sell $100 worth of bonds or other assets in exchange for $100 of its own paper dollars. This will soak up the unwanted paper and head off peoples’ desire to redeem the $100 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 dollar at one ounce of silver without ever redeeming any paper dollars 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.

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