Also called a bill, note, or paper money.
A piece of paper (bill) that is regarded as legal tender. It can be used as currency for commercial and financial transactions. The ability to exchange the banknotes for goods or services is part of the utility that gives it value.
Central Bank Money
There are two forms of central bank money under fractional reserve banking.
These are:
- banknotes
- reserves
The central bank issues banknotes, or the physical currency. This is often termed cash. They are distributed through the commercial banks and have the greatest liquidity. When it comes to accounting, cash and cash equivalent assets are ranked based upon this feature.
Banknotes are liabilities on the central bank's balance sheet. Cash is an asset on all other balance sheets. Since the Fed is the one who issues the notes, it is a liability against their assets.
Settlement is also considered instant. Financial transactions are non-reversible when they are settled. With cash, the transaction is fully settled at the time of payment, when banknotes are handed over.
Each note has a specific face value. There is no intrinsic value to banknotes. This is unlike coinage which can derive value from the metallic content in each coin.
Money Supply
Banknotes are a part of a country's money supply. This is the most basic form of currency.
Money evolves over time. With the advancement in technology, we saw the progress into the electronic and digital age. This altered how banks, financial institutions, and commerce took place.
As business shifted, so did money. There are tens of trillions of dollars in transactions done each day yet a miniscule number occur utilizing banknotes. Ledger based money has dominated for centuries. For example, by early 1900s, in terms of total dollars, checks were the most common form of payment.
Most of the money supply is made up of the digital currency. Fractional reserve banking places the creation of money supply in the hands of commercial banks. It is expanded through the use of loans.
Banks are required to keep only a portion of their deposits liquid. This can be either vault cash (banknotes) or digital units. The excess can be lend out, increasing the money supply. Since the new money ends up deposited, it shows up as assets to the commercial banking system.
Vault Cash
For the money supply to increase due to banknotes, the commercial banks must be willing to increase their vault cash.
Banks tend not to want to deal with physical currency. It requires personnel to count, room to house, and is slow. A digital medium is more accommodating to them.
Friction within the financial arena increases costs. Banks find that dealing with banknotes, something most of the public avoids, as too inefficient.
For the USD, most of the banknotes exit the country. Since the dollar is the reserve currency, much of the global population would prefer to deal in dollars as compared to their native currencies. Banknotes are often the only way to utilize this currency since the banking system is going to deal in the local currency.
History
Paper currency first developed in Tang dynasty China during the 7th century, although true paper money did not appear until the 11th century, during the Song dynasty. European explorers like Marco Polo introduced the concept in Europe during the 13th century. Napoleon issued paper banknotes in the early 1800s.
Over time, the perception of banknotes changed.
Since early forms of money were precious metals, paper money was originally a promissory note or IOUs tied to the metals. It was basically a promise to pay with coinage later. These are readily accepted and became the norm in the 1600s.
As precious metals were removed from the monetary system, banknotes became fiat currency.
During the 1800s, many banks offered their own banknotes. People would deposit gold or some other metal and receive a banknote in return. Anyone holding the note could redeem it for the metal in the bank. It was due to this that it acted as a medium of exchange.