The promissory clause printed on the banknotes i.e., “I promise to pay the bearer the sum of Rupees …” followed by the RBI governor’s signature, denotes the obligation on the part of the issuer of the note towards the holder of the bank note.
As per Section 26 of the Reserve Bank of India Act, 1934, the Bank is liable to pay the value of the banknote. This is payable on demand by RBI, being the issuer.
Although the Reserve Bank of India promises to pay the value mentioned in the notes, today’s paper currencies have no inherent value in them. The real value of today’s Rs.500 note is not the same after 10 years, because of inflation. It means the note is less worth than its value after 10 years by way of tangible goods or commodities. So, we understand that the note in itself is not 500 rupees; it is only a ‘promise’ that this sum will be paid to its possessor.
Background:
In ancient times precious metals like Gold and Silver acted as the currency. This is why we see that the ancient coins were made of precious metals. And there was no need for anybody to make a promise about the value of a Gold coin because the coin in itself contained precious Gold, unlike today’s paper currency.
When paper currency began to supplement coins in Britain some 300 years ago, each promissory note was backed by the country’s gold reserve. But over the period, countries went off the gold standard and started issuing notes under a minimum reserve system based on the demand for the notes from the public.
The unlimited notes and coins issued under the minimum reserve system are called Fiat money. The cost of issuing fiat currencies is paltry compared to their face value. Since the fiat currencies are issued and underwritten by the concerned government which is in principle, answerable to its citizen get their value by dint of regulation or law. One danger of fiat money is that governments can print too much of it, resulting in hyperinflation and the currency loses its value. The African nation of Zimbabwe provided an example of the worst-case scenario of fiat money in the early 2000s. In response to serious economic problems, the country’s central bank began to print money at a staggering pace; resulting in hyperinflation and the currency lost 99.9% of its value during that time.
So, the value of paper money is largely based on the public’s faith in the currency’s issuer, which is normally that country’s government or central bank. The note is rather, worth the confidence we have, in the paper that bears its denomination.
Original Article published in Banking School Blog
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