In this article we will discuss about the two types of monetary standards: A. Metallic Standard B. Paper Standard.
A. Metallic Standard:
Under metallic standard, the monetary unit is determined in terms of some metal like gold, silver, etc. Standard coins are made out of the metal. Standard coins are full-bodied legal tender and their value is equal to their intrinsic metallic worth. The important thing to note is that to be on a metallic standard a country must keep – (a) its monetary unit at a constant value in terms of the selected metal, and (b) its various types of money convertible into the selected metal at constant values.
Metallic standard may be of two types:
1. Monometallism
ADVERTISEMENTS:
2. Bimetallism.
1. Monometallism:
Monometallism refers to the monetary system in which the monetary unit is made up or convertible to only one metal. Under monometallic standard, only one metal is used as standard money whose market value is fixed in terms of a given quantity and quality of the metal.
Essential features of monometallic standard are given below:
ADVERTISEMENTS:
(i) Standard coins are defined in terms of only one metal.
(ii) These coins are accepted as unlimited legal tender in the discharge of day-to-day obligations.
(iii) There is free coinage (i.e., manufacture of coins) of the metal.
(iv) There are no restrictions on the export and import of metal to be used as money.
ADVERTISEMENTS:
(v) Paper money also circulates, but it is convertible into standard metallic coins.
Monometallism can be of two types:
a. Silver Standard:
Under silver standard, the monetary unit is defined in terms of silver. The standard coins are made of silver and are of a fixed weight and fineness in terms of silver. They are unlimited tender. There is no restriction on the import and export of silver. The silver standard remained in force in many countries for a long period.
India remained on silver standard from 1835 to 1893. During this period, Rupee was the standard coin and its weight was fixed at 180 grains and fineness 11/12. The coinage of the Rupee was free and people can get their silver converted into coins at the mint. Similarly, silver coins could be melted into bullion.
Silver standard lacks universal recognition as compared to gold standard. There is greater instability of both internal and external values of money under silver standard because silver price fluctuates more than that of gold. Thus, as far as the metal is concerned, gold is preferred to silver in most of the countries.
b. Gold Standard:
Gold standard is the most popular form of monometallic standard; the monetary unit is expressed in terms of gold. The standard coins possess a fixed weight and fineness of gold. The gold standard remained widely accepted in most of the countries of the world during the last quarter of the 19th century and the first quarter of the 20th century.
ADVERTISEMENTS:
The U.K. was the first country to adopt the gold standard in 1816. She was also the first to abandon this standard in 1931. Germany adopted the gold standard in 1873, France in 1878 and the U.S.A. in 1900. Gradually, gold standard disappeared from different countries and finally it was completely abandoned by the world by 1936.
Gold standard is the most popular form of monometallic standard. Under gold standard, the monetary unit is expressed in terms of gold. The standard coins possess a fixed weight and fineness of gold. The gold standard remained widely accepted in most of the countries of the world during the last quarter of the 19th century and the first quarter of the 20th century. The U.K. was the first country to adopt the gold standard in 1816.
She was also dying first to abandon this standard in 1931. Germany adopted the gold standard in 1873, France in 1878 and the U.S.A. in 1900. Gradually, gold standard disappeared from different countries and finally it was completely abandoned by the world by 1936.
Gold standard has been defined differently by different monetary economists. According to D.H. Robertson, “Gold standard is a state of affairs in which a country keeps the value of its monetary unit and the value of a defined weight of gold at equality with one another.” According to Coulborn, “The gold standard is an arrangement whereby the chief piece of money of a country is exchangeable with a fixed quantity of gold of a specific quality.”
ADVERTISEMENTS:
In the words of Kemmerer, “a gold standard is a monetary system in which the unit of value, in which price and wages are customarily expressed, and in which the debts are usually contracted, consists of the value of a fixed quantity of gold in an essentially free gold market.”
Monometallic standard has the following advantages:
i. Simplicity:
ADVERTISEMENTS:
Since only one metal is used as a standard of value, monometallism is simple to operate and easy to understand.
ii. Public Confidence:
Since the standard money is made of a precious metal (gold or silver), it inspires public confidence.
iii. Promotes Foreign Trade:
Monometallism facilitates and promotes foreign trade. Gold or silver standard is easily acceptable as an international means of payment.
iv. Avoids Gresham’s Law:
ADVERTISEMENTS:
Monometallism avoids the operation of Gresham’s law. According to this law, when both good as well as bad money exist in the economy, bad money tends to drive out of circulation good money.
v. Self-Operative:
It makes the supply of money self-operative. If there is surplus money supply, the value of money will fall and the people will start converting coins into metal. This will wipe out the surplus money, thus creating a balance.
The following are the demerits of monometallism:
i. Costly Standard:
ADVERTISEMENTS:
It is a costly standard and all countries, particularly the poor countries, cannot afford to adopt it.
ii. Lacks Elasticity:
Monometallism lacks elasticity. Money supply depends upon the metallic reserves. Thus, money supply cannot be changed in accordance with the requirements of the economy.
iii. Retards Economic Growth:
Economic growth requires expansion of money supply to meet the increasing needs of the economy. But, under monometallism, scarcity of metal may create scarcity of money supply which, in turn, may hinder economic growth.
iv. Lacks Price Stability:
ADVERTISEMENTS:
Since the price of the metal cannot remain perfectly stable, the value of money (or the internal price level) under monometallism lacks stability.
2. Bimetallism:
Bimetallism is a monetary system which attempts to base the currency on two metals. According to Chandler, “A bimetallic or double standard is one in which the monetary unit and all types of a nation’s money are kept at constant value in terms of gold and also in terms of silver.” Under bimetallism two metallic standards operate simultaneously.
Two types of standard coins from two different metals (say gold and silver) are minted. Both the types of standard coins become unlimited legal tender and a fixed ratio of exchange based on mixed ratio of exchange based on mint parity is prescribed for them. Provisions for unlimited purchase, sale and redeem-ability are extended to both metals.
(i) A bimetallic standard is based on two metals; it is the simultaneous maintenance of both gold and silver standards.
(ii) There is free and unlimited coinage of both metals.
ADVERTISEMENTS:
(iii) The mint ratio of the values of gold and silver at the mint is fixed by the government.
(iv) Two types of standard coins (i.e., gold coins and silver coins) are in circulation at the same time.
(v) Both the coins are full-bodied coins. In other words, the face value and the intrinsic value of both the coins are equal
(vi) Both the coins are unlimited legal tenders. They are also convertible into each other.
(vii) There is free import and export of both the metals.
The merits of bimetallism are discussed below:
i. Convenient Full-Bodied Currency:
Bimetallism provides convenient full-bodied coins for both large and small transactions. It provides portable gold money for large transactions and convenient silver money for smaller payments. This argument has, however, lost its force now when credit money has developed.
ii. Price Stability:
Under this monetary system, the shortage of one metal can be offset by increasing the output of the other metal. Consequently, stability in the prices of both the metals and hence, in the internal prices can be ensured.
iii. Exchange Rate Stability:
Bimetallism ensures stability of exchange rate. As long as gold and silver are stabilised in terms of each other, the currencies of all countries with fixed values in gold or in silver would exchange for each other at nearly constant rates.
iv. Sufficient Money Supply:
Under bimetallism, sufficient money supply is assured to meet the trade requirements of the economy. Since there is no question of both metals becoming scarce simultaneously, money supply is more elastic under this system.
v. Maintenance of Bank Reserves:
Under bimetallism, the maintenance of bank reserves becomes easy and economical. Under this system, both gold and silver coins are standard coins and unlimited tender. Therefore, it is easy for the banks to keep their cash reserves either in gold coins or in silver coins or in both.
vi. Low Interest Rates:
Since, under bimetallism, money is made of two metals, its supply is generally more than its demand. As a result, the interest rates decline. Banks can extend loans at cheaper rates. This would increase investment and hence production in the economy.
vii. Stimulates Foreign Trade:
Bimetallism stimulates international trade in two ways, – (a) A country on bimetallism can have trade relations with both gold standard and silver standard countries, (b) There are no restrictions on imports and exports due to the free inflow of both types of coins.
Bimetallism has the following demerits:
i. Operation of Gresham’s Law:
Bimetallism in a single country is a temporary and not workable monetary standard due to the operation of Gresham’s law. According to this law, when there is a disparity between the mint parity rate and the market rate of exchange of the two metals, bad money or the over-valued metal at the mint (whose mint price exceeds market price) tends to drive out of circulation good money or under-valued metal at the mint (whose market price exceeds mint price).
Thus, ultimately, single metal money (monometallism) will remain in practice. Thus, national bimetallism is only a temporary phenomenon. Only international bimetallism can prove permanent and practicable.
ii. Inequality between Mint and Market Rates:
Bimetallism can operate successfully only if the equality between the market rate and the mint rate can be maintained. But, in practice, it is difficult to maintain equality between the two rates, particularly when one metal is oversupplied than the other.
iii. No Price Stability:
The argument that bimetallism ensures internal price stability and there will be an automatic adjustment between supply and demand for money is illusionary. There can be a possibility of both the metals to become scarce.
iv. Payment Difficulties:
Bimetallism leads to difficult situation in the settlement of transactions when one party insists on payment in terms of a particular type of coins.
v. Encourages Speculative Activity:
It encourages speculative activity in the two metals when their prices fluctuate in the market.
vi. No Stimulus to Foreign Trade:
International trade is stimulated if all the countries adopt bimetallism. But, this is a rare possibility in the present circumstances.
vii. Costly Monetary Standard:
Bimetallism is a costly monetary standard and all nations, particularly the poor nations, cannot afford to adopt it.
Gresham’s Law:
Gresham’s law in its simple form states that when good and bad money are together in circulation as legal tender, bad money tends to drive good money out of circulation. This implies that less valuable money tends to replace more valuable money in circulation.
This law was enunciated by Sir Thomas Gresham who was the financial adviser to Queen Elizabeth I in the 16th century in England. Gresham was, however, not the first to develop this law, but it became associated with his name after he explained a problem faced by the Queen. With a view to reform the currency system, the Queen tried to replace bad coins of the previous regime by issuing new full-weighted coins.
But to her surprise, as soon as new coins were circulated, they disappeared and the old debased coins continued to remain in circulation. She sought the advice of Sir Thomas Gresham, who provided his explanation in the form of the law which states- “Bad money tends to drive out of circulation good money.”
The theoretical explanation of this law is in terms of the divergence of the market rate of exchange of the two currencies from mint rate. If the mint rate (i.e., the official rate of exchange between two types of money) differs from the market rate of exchange between the two types of money, then the over-valued money at the mint will tend to drive the under-valued money out of circulation.
Suppose under bimetallism, one gold coin exchanges for 10 silver coins, i.e., the official rate of exchange or the mint rate is 1:10. Now, if the market rate is 1:12, then gold is under-valued and silver is over-valued at the mint rate (i.e. the market rate of gold exceeds the mint rate and the market rate of silver is less, than its mint rate). In this case, gold will become good money and silver a bad money. The bad money (silver) will drive out good money (gold) from circulation.
When both good and bad money together are in circulation as legal tender, good money disappears in three ways:
i. Good Money is Hoarded:
When both good and bad money circulate simultaneously, people have the tendency to hoard good money and use bad money for making payment.
ii. Good Money is Melted:
Since both good coins and bad coins are in circulation and have the same value, people prefer to melt good coins to convert them into ornaments or other items of art.
In payments to the foreign countries, gold coins are accepted by weight and not by counting. Thus, it would be profitable to pay to the foreigners in terms of new full-weight coins rather than old and light-weight coins.
Gresham’s Law in General Form:
Gresham’s law, in its original form, applies only to debased coins of monometallic system (i.e., gold standard).
But, the law can, however, be extended to all forms of monetary standards:
1. Under Monometallism:
Under monometallism (for example gold standard), the old and worn out coins are regarded as bad coins and full-weight coins are considered as good coins. According to Gresham’s law, the old and worn out coins drive new and full- weight coins out of circulations.
2. Under Bimetallism:
Under bimetallism (generally a system of gold and silver coins), coins of overvalued metals are considered bad money and coins of under-valued metal as good money. Thus, according to Gresham’s law, the over-valued coins will drive under-valued coins out of circulation.
3. Under Paper Standard:
Under paper standard, if both standard coins of superior metal and inconvertible paper notes are in circulation, the metallic coins will be good money and paper notes will be bad money. Thus, paper notes will drive out standard coins from circulation.
Thus, Gresham’s law is a general law which can be applicable in different forms of monetary standards. Marshall presented a generalized version of the law – “Gresham’s law is that an inferior currency, if not limited in amount, will drive out the superior currency.”
Gresham’s law will operate if the following necessary conditions are satisfied.
In the absence of these conditions the law will fail to apply:
i. Usefulness of Good Money:
An important condition for Gresham’s law is that the intrinsically more valuable money (i.e., good money) must also be more valuable in other uses than it is as money in circulation. The failure of this condition to apply explains why the coin currency today remains in circulation as fairly as paper currency despite its higher intrinsic value.
ii. Fixed Parity Ratio:
The applicability of the law requires that the intrinsically more valuable money must be relatively fixed by law in its parity with money. The law will not hold where one money becomes intrinsically more valuable than another money (at the old parity) if the parity changes.
iii. Sufficient Money Supply:
The law will operate only if both good money and bad money are in circulation and the total money supply is more than the actual monetary requirements of the economy.
iv. Sufficient Supply of Bad Money:
The applicability of the law requires that there should be sufficient bad money in circulation to meet the transactions requirement of the people. If there is scarcity of bad money, both good and bad money will remain in circulation and the law will not operate.
v. Contents of Pure Metal:
The law will not operate if the contents of pure metal in coins are less than that in the old ones.
vi. Acceptability of Bad Money:
The law will operate if people are prepared to accept bad money in transactions.
vii. Distinction between Good Money and Bad Money:
The law assumes that people can distinguish between bad money and good money.
viii. Development of Banking Habit:
The law applies in the absence of banking habits. Development of banking habits among the people tends to discourage hoarding and thus restricts the operation of Gresham’s law.
ix. Convertibility:
The law also does not operate if the country is on inconvertible paper standard.
B. Paper Standard:
Paper standard refers to a monetary standard in which inconvertible paper money circulates as unlimited legal tender. Under paper money standard, although the standard money is made of paper, both currency and coins serve as standard money for purpose of payment. No gold reserves are required either to back domestic paper currency or to facilitate foreign payments.
The paper standard is known as managed standard because the quantity of money in circulation is controlled and managed by the monetary authority with a view to maintain stability in prices and incomes within the country. It is also called fiat standard because paper money is inconvertible in gold and still regarded as full legal tender. After the general breakdown of gold standard in 1931, almost all the countries of the world shifted to the paper standard.
Features of Paper Standard:
The paper standard has the following features:
(i) Paper money (paper notes and token coins) circulates as standard money and accepted as unlimited legal tender in the discharge of obligations.
(ii) The unit of money is not defined in terms of commodity.
(iii) The commodity value (or intrinsic value) of the circulating money is particularly nil.
(iv) Paper money is not convertible in any commodity or gold.
(v) The purchasing power of the monetary unit is not kept at par with any commodity (say gold).
(vi) Paper standard is national in character. There is no link between the different paper currency systems.
(vii) The foreign rate of exchange is determined on the basis of the parity of purchasing powers of the currencies of different countries.
Merits of Paper Standard:
Various merits of paper standard are described below:
1. Economical:
Since under paper standard no gold coins are in circulation and no gold reserves are required to back paper notes, it is the most economical form of monetary standard. Even the poor countries can adopt it without any difficulty.
2. Proper Use of Gold:
Wastage of gold is avoided and this precious metal becomes available for industrial, art and ornamental purpose.
3. Elastic Money Supply:
Since paper money is not linked with any metal, the government or the monetary authority can easily change the money supply to meet the industrial and trade requirements of the economy.
4. Ensures Full Employment and Economic Growth:
Under paper standard, the government of a country is free to determine its monetary policy. It regulates its money in such a way that ensures fall employment of the productive resources and promotes economic growth.
5. Avoids Deflation:
Under paper standard, a country avoids deflationary fall in prices and incomes which is the direct consequence of gold export. Such type of situation arises under gold standard when a participating country experiences adverse balance of payments. This results in the outflow of gold and contraction of money supply.
6. Useful during Emergency:
Paper currency is very useful in times of war when large funds are needed to finance war. It is also best suited to the less developed countries like India. To these economies, it makes available large amounts of financial resources through deficit financing for carrying out developmental schemes.
7. Internal Price Stability:
Under this system, the monetary authority of a country can establish stability in the domestic price level by regulating money supply in accordance with the changing requirements of the economy.
8. Regulation of Exchange Rate:
Paper standard provides more effective and automatic regulation of exchange rate, whereas, under gold standard, the exchange rate is absolutely fixed. Whenever, exchange rate fluctuates as a result of disequilibrium between demand and supply forces, the paper standard works on imports and exports and restores equilibrium. It allows the forces of demand and supply to operate freely to establish equilibrium.
Demerits of Paper Standard:
The paper standard suffers from the following defects:
1. Exchange Instability:
Since the currency has no link with any metal under paper currency, there are wide fluctuations in the foreign exchange rates. This adversely affects the country’s international trade. Exchanging instability arises whenever external prices move more than domestic prices.
2. Internal Price Instability:
Even the commonly claimed advantage of paper standard, i.e., domestic price stability, may not be achieved in reality. In fact, the countries now on paper standard experience such violent fluctuations in internal prices as they experienced under gold standard before.
3. Dangers of Inflation:
Paper standard has a definite bias towards inflation because there is always a possibility of over- issue of currency. The government under paper standard generally has a tendency to use managed currency to cover up its budget deficit. This results in inflationary rise in prices with all its evil effects.
4. Dangers of Mismanagement:
Paper currency system can serve the country only if it is properly and efficiently managed. Even the minor mistake in the management of paper currency can bring such disastrous result that cannot be conceived of in any other form of monetary standard. If the government issues little more or little less currency than what is required for maintaining price stability, it may lead to cumulative inflation or cumulative deflation.
5. Limited Freedom:
In the present world of economic dependence, it is almost impossible for a particular country to isolate itself and remain unaffected from the international economic fluctuations simply by adopting paper standard.
6. Absence of Automatic Working:
The paper standard does not function automatically. To make it work properly, the government has to interfere from time to time.
Principles of Note Issue:
At present, all the countries of the world have adopted paper standard.
In fact this standard has proved a boon to the modern monetary system. The central bank of a country, which plays an important role in the paper standard, is assigned the job of note issue.
A good note issue system should possess the following qualities:
(a) It should inspire public confidence, and, for this, it must be based on sufficient reserves of gold and silver.
(b) It should be elastic in the sense that money supply can be increased or decreased in accordance with the needs of the country.
(c) It should be automatic and secure.
To ensure a good note issue system, two principles of note issue have been advocated:
(1) Currency principle and
(2) Banking principle.
1. Currency Principle:
The currency principle is advocated by the ‘currency school’ comprising Robert Torrens, Lord Overstone, G. W. Norman and William Ward. Currency principle is based on the assumption that a sound system of note issue should command the greatest public confidence. This requires that the note issue should be backed by 100 per cent gold or silver reserves. Or in other words, paper currency should be fully convertible into gold or silver.
Thus, according to the currency principle, the supply of paper currency is subjected to the availability of metallic reserves and varies directly with the variations in the metallic reserves.
Merits:
The currency principle has the following advantages:
(i) Since, according to this principle, the paper currency is fully convertible into gold and silver, it inspires maximum confidence of the public.
(ii) There is no danger of note issue of the paper currency leading to the inflationary pressures,
(iii) It makes the paper currency system automatic and leaves nothing to the will of the monetary authority.
Demerits:
The currency principle has the following drawbacks:
(i) The currency principle makes the monetary system inelastic because it does not allow the monetary authority to expand the money supply according to the needs of the country.
(ii) It requires full backing of gold reserves for note issue. Thus, it makes the monetary system expensive and uneconomical.
(iii) This principle is not practical for all countries because gold and silver are unevenly distributed among countries.
2. Banking Principle:
The banking principle is advocated by the ‘banking school’, the important members of which are Thomas Tooke, John Fullarton James, Wilson and J.W. Gilbart. The banking principle is based on the assumption that the common man is not much interested in getting his currency notes converted into gold or silver.
Therefore 100 per cent metallic reserves may not be necessary against note issue. It is sufficient to keep only a certain percentage of total paper currency in the form of gold or silver reserves. The banking principle of note issue is derived from the practice of the commercial banks to keep only a certain proportion of cash reserves against their total deposits.
Merits:
The following are the merits of banking principle:
(i) The banking principle renders note issue system elastic. The monetary authority can change the supply of currency according to the needs of the economy.
(ii) Since the banking principle does not require 100 percent metallic backing against the note issue, it is the most economic principle and thus can be followed by both rich and poor countries.
Demerits:
The banking principle has the following demerits:
(i) The banking principle is inflationary in nature, because it involves the danger of over-issue of paper currency.
(ii) The monetary system based on the banking principle does not command public confidence because the system is not fully backed by metallic reserves.
Conclusion:
The main conclusion regarding the two principle of note issue is:
(i) Both the currency principle and the banking principle fail to satisfy all the, requirements of a good note issue system. The currency principle ensures security and public confidence, but it lacks elasticity, economy and practicability. On the contrary, the banking principle provides elasticity and economy to the note issue system, but it suffers from the drawbacks of over-issue and loss of public confidence.
(ii) Despite the incompleteness of both the principles, the banking principle, rather than the currency principle, has been preferred and widely accepted in the modern times mainly because of its emphasis on the qualities of elasticity, economy and practicability of the note issue system. The quality of convertibility, which is basic to the currency principle, is no longer considered as necessary requirement for a good note issue system.
Methods of Note Issue:
Different countries have adopted various methods of note-issue in different periods.
Important methods of note-issue are discussed below:
1. Simple Deposit System:
Under the simple deposit system, the paper currency notes are fully backed by the reserves of gold or silver or both. This system is based on the currency principle of note issue. This method involves no danger of over-issue of currency and commands maximum degree of public confidence. But, this system has never been practised because it is very costly and has no elasticity of money supply.
2. Fixed Fiduciary System:
Under the fixed fiduciary system, the central bank is authorised to issue only a fixed amount of currency notes against government securities. All notes issued in excess of this limit should be fully backed by gold and silver reserves. Fiduciary issue means the issue of currency notes without the backing of gold and silver. This system was first introduced in England under the Bank Charter Act of 1844 and still prevails there. India followed this system between 1862 to 1920.
Merits:
Fixed fiduciary system has the following advantages:
(i) It ensure convertibility of currency notes.
(ii) It inspires public confidence since the government guarantees the convertibility of notes.
(iii) There is no danger of over-issue of paper notes because barring a certain portion, the entire note issue is backed by gold reserves.
Demerits:
The main disadvantages of the fixed fiduciary system are:
(i) It makes the monetary system less elastic. In times of economic crises, money supply cannot be increased without keeping additional gold in reserve.
(ii) It is a costly system which requires sufficient gold reserves. Poor countries cannot afford to adopt it.
(iii) It is inconvenient method because whenever gold reserves fall, the central bank has to reduce the supply of currency which greatly disturbs the functioning of the economy.
3. Proportional Reserves System:
Under the proportional reserve system, certain proportion of currency notes (40%) are backed by gold and silver reserves and the remaining part of the note issue by approved securities. India adopted this method on the recommendation of Wilton Young Commission.
According to the Reserve Bank of India Act 1933, not less than 40 per cent of the total assets of the Issue Department should consist of gold bullion, gold coins and foreign securities, with the additional provision that gold coins and gold bullion were not at any time to be less than Rs. 40 crores. The proportional reserve system was later replaced by the minimum reserve system by the Reserve Bank of India (Amendment) Act, 1956.
Merits:
The proportional reserve system has the following advantages:
(i) It guarantees convertibility of paper currency.
(ii) It ensures elasticity in the monetary system; the monetary authority can issue paper currency much more than that warranted by reserves.
(iii) It is economical and can be easily adopted by the poor countries.
Demerits:
The proportional reserves system suffers from the following defects:
(i) Under this system, it is easy to expand currency but very difficult to reduce it. The reduction of currency has deflationary effects in the economy.
(ii) There is wastage of gold because large amount of gold lies in the reserve and cannot be put to productive use.
(iii) The convertibility of paper notes is not real. In practice, high denomination notes are converted into low denomination notes and not into coins.
4. Minimum Fiduciary System:
Under the minimum fiduciary system, the minimum reserves of gold against note issue that the authority is required to maintain are fixed by law. Against these minimum reserves, the monetary authority can issue as much paper currency as is considered necessary for the economy. There is no upper limit fixed for the issue of currency.
Minimum fiduciary system is based upon two considerations:
(a) The central bank feels that there should not be any restriction on the note issue, especially when the demand for currency is fast increasing,
(b) In the modern age, when bank deposits assume greater significance as an important constituent of money supply, the convertibility of notes into gold need not be bothered about.
The minimum fiduciary system, if ably managed, can prove very useful for developing countries. It can make available enormous resources for financing developmental schemes. Similarly, during inflation, the monetary authority can control the money supply. This system has been in force in India since 1957. The Reserve Bank of India is required to keep minimum reserves of Rs. 200 crores of which not less than Rs. 115 crores must be kept in the form of gold.
Merits:
The minimum reserve system has the following advantages:
(i) The system is economical because the entire note issue need not be backed by metallic reserves. Only a minimum reserve is to be maintained.
(ii) It renders elasticity to the monetary system. After maintaining the minimum reserves, the monetary authority can issue any amount of currency that it feels necessary.
The minimum reserve system has the following drawbacks:
(i) Since, under this system, no additional reserves are required for increasing the supply of currency, there is always a tendency towards the over-issue of currency, and hence an inherent danger of inflationary pressures.
(ii) Since the system provides no convertibility of currency notes into gold, it lacks public confidence.
5. Maximum Reserve System:
Under this system, the government fixes the maximum limit upto which the monetary authority can issue notes without the backing of metallic reserves. The monetary authority cannot issue notes beyond this limit. The maximum limit is not rigid and may be revised from time to time according to the changing needs of the economy.
This system was followed by France and England upto 1928 and 1939 respectively. Under this system, the Central bank is given the power to determine the maximum limit and thus an element of elasticity is introduced in the system of note issue. The system, however involves the dangers of over-issue and loss of public confidence when the maximum limit is raised and additional currency is circulated without the backing of metallic reserves.
The following conclusions emerge from the discussion of various methods of note issue:
(i) The analysis of relative merits and demerits of various methods of note issue makes it difficult to identify any one method as an ideal method.
(ii) A good method of note issue must possess the qualities of economy, elasticity and public confidence without being inflationary in effect.
(iii) Convertibility of currency notes into some precious metal is no longer considered an important requirement because in modern times currency notes are accepted on their own merit.
(iv) Keeping in view these considerations, minimum fiduciary system can prove to be a better method, if managed ably and sincerely.
Ideal Monetary System:
An ideal monetary standard should be able to achieve the twin objectives of – (a) growth and full employment with reasonable price stability within the country, and (b) smooth flow of goods, services and capital at the international level. Such an ideal monetary system requires wise blending of both paper and gold standards. This blending will provide the advantages of both the standards, with none of their disadvantages.
In modern times, the establishment of International Monetary Fund (IMF) and the International Bank of Reconstruction and Development (IBRD) has been designed to give the ideal monetary system a practical shape. These institutions have been able – (a) to make the paper standard function efficiently both internally and internationally by removing its various defects; and (b) to operate international affairs quite successfully, thus promoting trade and cooperation among the nations.