Banking Awareness: Methods of Managing Paper Money
Principles of Note Issue:
There are two basic principles of managing the issue of paper money, Currency Principle and Banking Principle. The Currency Principle assumes that paper money will command the confidence of people only if it is convertible into gold or silver. In other words, for every note issued by the monetary authority, there should be an equivalent amount of gold or silver in the currency reserve so as to guarantee 100% convertibility of the paper money, if need be. The only advantage of following this principle is the saving of wastage involved in the circulation of metallic currency. But the issue of paper money is also restricted in the process because monetary gold may not be available adequately for increasing the volume of notes. Thus, the system is found to be highly inelastic.
According to the Baking Principle, the metallic reserve against the issue of paper currency need not be held in the ratio of 1:1. To sustain public confidence it may be enough to hold a certain proportion of the money supply in metallic reserve. This is because every one is not interested in converting paper currency into gold. Indeed none may be so inclined under normal conditions. The banking principle gives more elasticity to the currency system. It is also economical as it does not require 100% metallic reserve against the paper money in circulation. The monetary authorities can regulate the money supply within a wider range at their discretion.
Methods of Managing Paper Money
The monetary systems involving the issue of paper currency are scarcely based on the principle of "100% reserve ". By and large, the principle followed is that of "Partial reserve" or "Partial deposit". In practice, several versions of the "Partial deposit" plan have been in use.
1) Fixed Fiduciary System of Notes Issue:
This method of note issue permits the monetary authority to issue a fixed amount of paper money without any metallic reserve backing. Any amount in excess of that limit is required to be covered fully by gold or silver resources. This method prevents unlimited expansion of paper currency and thus a check on inflation. But it is rigid and inflexible method and is unsuitable for an expanding economy as well as in those cases where changers in money supply are needed to suit seasonal changes in the demand for money.
2) Maximum Fiduciary System:
Under this system of note issue, a maximum limit is fixed by the government for the issue of paper currency without metallic reserves. Thus the monetary authorities or the central bank must seek Government approval to raise the existing limit when it is necessary to expand money supply.
This method provides a safe limit to the volume of note issue and the possible danger of inflation through over-issue of paper money is avoided. However, the danger of over-issue is not completely absent for the Government can always raise the limit to suit its convenience.
3) Proportional Reserve System:
Under the proportional reserve system, a certain proportion (say, 30 or 40%) of the note is required to be covered by metallic reserves. The monetary authorities can expand the volume of money supply with 30 to 40% of the amount covered by metallic reserve. The chief advantage of this method is that there is perfect flexibility with a restraint on unlimited issue. It also economises in the use of gold and silver in currency reserve. A minor objection sometimes made against this method is that it involves permanent locking up of gold and silver in the monetary reserve.
4) Minimum Reserve System:
The method of note issue under which there is no upper limit of note issue prescribed as long as a minimum amount of metallic reserve is maintained, is known as the Minimum Reserve System. This method provides maximum flexibility to currency system, and currency expansion can be made according to necessity. It is thus very suitable for a developing economy like India. Indeed, the Indian currency system is now based on the Minimum Reserve System of note issue. However, the elasticity of this system also involves the danger of over issue for financing the revenue gaps of the Government.
Important Links:
Important Links:
- Banking Awareness: About Policy Rates and Reserve Ratios
- Banking Awareness: Structure of Indian Banking System
- Banking Awareness: All about NABARD
0 comments: