What Are Banknotes and How Are They Used?

What Is a Banknote?

A banknote is a negotiable promissory note which one party can use to pay another party a specific amount of money. A banknote is payable to the bearer on demand, and the amount payable is apparent on the face of the note. Banknotes are considered legal tender; along with coins, they make up the bearer forms of all modern money.

A banknote is known as a "bill" or a "note."

Key Takeaways

  • A banknote is a "bill" or form of currency that one party can use to pay another party.
  • In the U.S., only the Federal Reserve Bank is allowed to print banknotes for money.
  • While banknotes used to be backed by precious metals such as gold and silver, in 1971, the United States government went off the gold standard, making American banknotes a fiat currency that is backed instead by good faith.

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How Banknotes Work

Before modern societies and financial systems were set up, people used valuable objects, such as gold and silver, to pay for goods and services through bartering. Eventually, paper money and coins replaced these physical assets as representative currency. When this happened, precious metals backed the new currencies to give it credibility.

At present, only the government backs banknotes. Although in earlier times commercial banks could issue banknotes, the Federal Reserve Bank is now the only bank in the United States that can create banknotes and mint money. Worldwide, billions of financial transactions use banknotes every day.

Historically, U.S. citizens could exchange U.S. government-issued paper money for gold or silver. This bimetallic standard system consisted of paper currency in a fixed ratio with gold and/or silver. However, in 1964, the U.S. government gradually began to halt the bimetallic standard; in 1971, the U.S. went off the gold standard altogether. The decision created a pure fiat currency, which the government supported only with its good faith in its ability to pay off any debts.

Fiat money derives its value from the relationship between supply and demand, not the value of the currency’s physical material. Since fiat money is not linked to physical reserves, it risks becoming worthless, due to hyperinflation. For example, if in a distant future U.S. citizens lose faith in the U.S. dollar bill, this paper currency will no longer hold value. Luckily, the likelihood of the U.S. dollar collapsing is very low.

Many use the terms banknotes, currency notes, and bills interchangeably. While both are promissory notes, many use currency notes more frequently for common dealings.

Polymer Banknotes and the Bank of England

In 2013 the Bank of England considered introducing polymer banknotes. These plastic-like banknotes, which Canada and many other nations worldwide use, are easier to clean and harder to counterfeit. The pros of introducing polymer banknotes also include their enhanced security features, reduced replacement costs (as polymer lasts two and a half times longer than paper), waterproofing, dirt-resistance, and overall lower negative environmental impacts. Cons to introducing polymer banknotes into Britain’s monetary system included a higher upfront manufacturing cost, counting difficulties – given that the material is slipperier than paper — challenges in folding the new material, and questionable compatibility with existing vending machines and auto-payment systems.