Methods of Note Issue

7/21/2019 Methods of Note Issue

1/8

Methods of Note Issue

Both the principles of, note issue mentioned above, have serious defects. The monetary experts

by coordinating the advantages of both the principles have evolved various systems or methods

of notes issue. The main systems of note issue prevalent in different countries of the world are

(1) Partial Fiduciary System. (2) Proportional Reserve System. (3) Minimum Reserve System.

These systems are now discussed in brief.

(1) Fixed Fiduciary System.Under this system, a fixed amount is laid down by law which need

to be covered by government securities. Notes issued in excess of this amount must be fully

backed by gold. England adopted this system in 1844. The system lacked elasticity and was not

capable of satisfying the needs of trade and industry. This system was abandoned in 1913 in

favour of proportional reserve system.

(2) Proportional Reserve System.Under this system, the central bank is to keep a certain

percentage of the total notes issued in gold. The r is to be covered by sound government

securities, trade bills etc. This system remained prevalent in USA, Great Britain and over a large

part of the world. The proportional reserve system was also adopted by State Bank of Pakistan

(SBP) and it remained enforced till December 1965. This system was abandoned in 1965 as it

was rigid and lacked elasticity. The State Bank of Pakistan could not give guarantee for full

convertibility of notes. The State Bank of Pakistan has now adopted a new system of note issue

named as Minimum Reserve System.

(3) Minimum Reserve System.The proportional reserve system of note issue has been

replaced by minimum reserve system in Pakistan in 1965. According to this system, the central

bank is required to keep only a minimum amount of reserve in the form of gold and foreign

exchange securities. The central bank can expand note issue in accordance with the volume of

business activities without backing of gold. The level of currency backing by gold is fixed at Rs.

1200 million in Pakistan. The merit of this system is that it ensures an adequate supply of

currency to meet the business demands of the country. In other words, the method of note issue

is sufficiently elastic. The demerit is that paper currency issued is practically inconvertible in this

system.

PRINCIPLES OF NOTE ISSUE :-There are two principles of note issue. First is the currency principle and the second is banking

principle. There are different views about these principles. One school of thought says that there

should be full convertibility of notes into gold bullion. The second gives importance to the elasticity

of supply. Now we discuss these two principle.

CURRENCY PRINCIPLE :-

The lover of this principle say that paper money is better than the metallic money but there should

be 100% backing ofgoldreserves. They say that in order to maintain the prestige of paper money

gold should be available for the conversion of notes when presented.

ADVANTAGES :-
http://studypoints.blogspot.com/http://studypoints.blogspot.com/http://studypoints.blogspot.com/http://studypoints.blogspot.com/


2/8

i. Safety And Security :-

The advantage of this system is that it gives full safety and security to the paper currency.

ii. No Danger Of Over Issue :-

There is no danger of over issue of the currency. So it is an effective check on inflation.

DISADVANTAGES :-

i. Inelastic :-

The disadvantage of this principle is that it makes the supply of money inelastic. According to this

principle paper currency can only be printed and issued if there is a 100% gold cover available

against it. So this system can not meet the requirement of trade and industry.

ii. Lock Up Of Gold :-

A huge amount of gold is unnecessarily locked up which can be used in other productive projects.

BANKING PRINCIPLE :-

According to this principle there is no need of reserve requirements of gold and silver for the notes

issued. The banks are authorized to regulate the note issue keeping in view the need of the business

in the country. The banks themselves will maintain adequate reserves of gold for meeting their

obligations of note. If there is an over issue of notes, the excess money will be automatically

presented for cash payment and proper ratio will be maintained between the supply of money and

the gold reserves.

MERITS AND DEMERITS OF ELASTIC SYSTEM :-

The merit of this principle is that it secures elasticity in the issue of currency.

Not Safe :-

The demerits of this principle is that it is not a safe. In the history of England banking, many times

over issuance of money created problems for the economy.

Conclusion :-

After discussing both the principles we can say that both are defective. For a sound system of not

issue security and elasticity must go side by side. Keeping in view the above defects modern world

have devised new methods of regulating note issue.

METHODS OF NOTE ISSUE :-

Fixed Fiduciary System :-

Under this system the central bank of the country is permitted to issue bank notes of a given amount

without giving gold and silver cover. The fixed quantity of notes allowed by law to be issued is to be

backed by Govt. securities only. This is named the fiduciary limit. The amounts of notes circulated in

excess of the fiduciary limit must be 100% backed by gold.


3/8

ADVANTAGES :-

1. Elastic System :-

The first advantage of this system is that it makes the supply of money elastic.

2. Safety :-

It also gives maximum safety because notes can not be issued in excess of the fiduciary limit unless

they are 100% covered by gold.

3. Check On Inflation :-

The inflation can be effectively checked.

DISADVANTAGES :-

1. High Fiduciary Limit :-

If fiduciary limit is high or it has been increased with the passage of time then people will loose

confidence in the currency.

COUNTRIES :-

1. Great Britain is considered the home of this system of note issue and it has successfully survived

since 1844.

2. Japan and Norway are also practicing this system of note issue even today.

PROPORTIONAL RESERVE SYSTEM or PERCENTAGE SYSTEM :-

According to this system the central bank is required by law to keep a fixed percentage varying from

25 to 40 percent against the note issue. The essential feature of this system is the provision of

proportional metallic reserves against the notes in circulation. The reserve ratio may be allowed to

drop below the legal minimum.

COUNTRIES :-

1. It was adopted by France and reserve ratio was 30%.

2. Germany adopted it keeping 40% of gold against the note issue.

3. The federal reserve Bank of U.S.A has also adopted it with slight modification.

ADVANTAGE AND DISADVANTAGE :-

1. Elastic System :-

The main advantage of this system is that it makes the supply of money elastic.

2. Lock Up Of Gold :-

The defect with this system is that it locks up the gold reserves unnecessarily. So we cannot use it for

other purpose.

3. Exchange Management or Modified Proportional Reserve System :-


4/8

J.M. Keynes has suggested modified form of proportional reserve system and calls it exchange

management. According to this system the central bank is required by law to keep the percentage

required against the note issue in the form of gold, foreign bills or cash at some foreign banks where

gold standard prevails.

COUNTRIES FOLLOWED :-

This method is followed in India, Pakistan and in many European Countries. The state bank of

Pakistan has to keep 30% of gold silver or approved foreign exchange against the note issue. This

method of note issue economies the use of gold and also makes the currency system elastic.

There are two principles of note issue. The first is the currency principle and the second is banking

principle. There are different views about these principles. One school of thought says that there

should be full convertibility of notes into gold bullion. The second gives importance to the elasticity

of supply.

1. Currency Principle:

According to the advocates of the currency principles, the paper money is an economical and

convenient substitute of metal money. They insist that paper money in circulation should be backed

by 100% gold reserves. There will always be availability of gold for the redemption of notes when

presented which creates stability in price level and exchange rates, because every note issued is

covered by gold behind it.

2. Merits

2.1. Safety and Security:

It gives full safety and security to the paper currency.

2.2. No Danger Of Inflation:

There is no danger of over-issue of the currency, which is an effective check to the possibilities ofinflation.

2.3. Public Confidence:

The currency principle provides greater confidence to the public, because it provides assurance in

ease of convertibility of notes.

3. Demerits

3.1. Inelastic:


5/8

It makes the supply of money highly inelastic, because the issuance of notes is only possible on the

availability of gold. So, the government cannot issue notes in case of emergency.

3.2. Dependent:

According to this principle, paper currency can only be primed and issued if there is 1009b goldcover available against it. The issuance of currency thus completely depends upon the availability of

gold rather than the trade and industry need.

3.3. Lock up of Gold:

There is unnecessary lock up of gold for the currency, which may be used for some other purposes.

3.4. Real World:

It is not acceptable in the real world and has no support from all over the world.

4. Banking Principle:

According to this principle, there is no need to have the reserve of gold and silver for the issuance of

notes. The banks are authorized to regulate the note issue keeping in view the needs of trade and

industry The banks themselves maintain adequate reserves of gold for meeting the obligations of

notes. If there is an over issue of notes, the excess money will be automatically presented for cash

payment and thus the proper ratio will be maintained between the supply of money and the gold

reserves.

4.1. Merits

4.2. Elastic System:

The banking principle is elastic because gold is not kept for current percent value of notes issued.

4.3. Government needs:

This system is fit for meeting the government needs in case of emergencies.

4.4. Popularity:

This system is popular all over the world. Every country is issuing money under this system.

4.5. Surety:

It also provides surety for the convertibility of notes.

4.6. Demerits

4.7. Over-Issue:

In order to meet the demand for money, there may be a further issue of notes beyond to a certain

limit which leads to inflation.

4.8. Economic Crisis:


6/8

During economic crisis the convertibility of notes may be refused.

4.9. Balance of Payment:

This is not good for keeping the stable exchange rates. Whenever there is a change in

foreign, exchange rates, the balance of payment position becomes more unfavorable.

Meaning of Monetary Standard

The term monetary standard refers to the monetary system of a country. Prof. Halm defines

monetary standard as the principal method of regulating the quantity and the exchange value of

standard money. When the standard money of a country is chosen in the form of some metal, then

the country is said to have metallic standard. There are three main types of monetary standards.

They are:

1. Monometallism or Single Standard

2. Bimetallism or Double Standard

3. Paper Currency Standard (Managed Currency Standard)

Monometallism or Single Standard

When only on metal is adopted as the standard money and is made legal tender for all payments,

the system is known as monometallism or single standard. For example, now many countries have

the Gold Standard. Suppose a country has adopted silver as the standard money, then it is said tohave Silver Standard. For example, England was on Silver Standard until 1816.

Bimetallism or Double Standard

If two metals are adopted as standard money and if a legal ratio is established between the value of

the two metals, then the system known as bimetallism or double standard. In other words, under

this system, gold and silver circulated as legal tender money and there was a legally fixed ratio of

exchange between them. Usually, two metals used under bimetallism are gold and silver.

Bimetallism was adopted in France in 1803. Later on, it was adopted by other countries like Belgium,

Switzerland and Holland. Bimetallism has certain advantages and disadvantages.

Advantages

1. It would secure greater stability of prices. It there is monometallism, the supply of only one

metal could not satisfy the monetary demand satisfactorily. The increasing demand for

money should be accompanied by an increase in the supply of money. Otherwise, there

cannot be a stable price level. Therefore, if there is bimetallism, the supply of two metals put

together will be steadier than that of any one of them. Just as two drunkards might walk

more steadily when they walk hand in hand, the supply of two metals under bimetallism will

make price level more stable.


7/8

2. Bimetallism would promote stable exchange rates between countries using gold and

countries using silver.

3. The supply of gold would not be sufficient for the currency requirements if all countries

adopted gold standard, that is, if they adopted universal monometallism.

4. Bimetallism will keep world prices stable.

Disadvantages

1. There is a great difficulty in maintaining the mint ratio (legal ratio) between the two metals

because market ratio will often fluctuate.

2. Greshams law that bad money drives out good money will operate.

3. Bimetallism cannot work if only one country adopted it. All countries in the world should

adopt it.

4. It may result in a lot of confusion, particularly, if there are differences between the legal

ratio and market ratio of the two metals. So bimetallism may not remedy the defects of gold

standard; it may increase the difficulties.

Paper Currency Standard (Managed Currency Standard)

Under the system, as the name indicates, the currency of the country will be in paper. Paper money

consists of bank notes and government notes. Generally, under the system, the currency system will

be managed by the Central Bank of the country. Hence, the system sometimes is referred to as

managed paper currency standard. Almost all countries in the world have managed currency

standard. The paper currency has certain advantages and disadvantages.

Advantages and Disadvantages of Paper Money

Paper money is economical. Its cost of production is negligible. It is convenient to handle and it is

easily portable. It is homogeneous. Its supply can be made elastic. And its value can be kept stable by

proper management. Paper currency can function very effectively as money, provided, there is

proper control of it by the managing authority. It is ideal for internal trade. But for international

trade and payments, gold is still found necessary.

However, paper money has two great disadvantages. There is the danger of over-issue of paper

money by the managing authorities. Over-issue of currency will result in a rise in prices, adverse

foreign exchange rates and many other evils. The over-issue of paper money has ruined many

countries in the past. Another disadvantage of paper money is that it will not have universal

acceptance. It is recognized as money only in the country where it is issued. For others, paper money

is just bits of paper. Gold, on the other hand, has universal acceptance.

MONETARY STANDARD :-

Monetary standard is the unit of account by which we measure the value of all kinds goods and

services. The monetary standard or standard money can be gold, silver or paper. If the unit of account

is gold we will say that it is a gold standard.


8/8

MONETARY SYSTEM :-

Monetary system includes in its scope the designation of the unit of account plus the whole Govt.

Mechanism established to regulate the creation of money and to control its quality in circulation. The

monetary system is designed in every country according thedomesticand international requirements.

1. COMMODITY STANDARD :-

A commodity standard is that monetary unit which has its standard value equal to the value of a

designated quantity of a particular commodity or of a group of commodities. The commodity standard

can be established in gold or silver or in both.

2. FIAT STANDARD :-

According to Kent, "A monetary system in which the value or purchasing power of the monetary unit is

not kept equal to the value of a specified quantity particular commodity or of a group of a

commodities".

It has three distinguished features.

i. It has little or no value within itself as a commodity.

ii. It is not redeemable in any commodity in quantity substantially equal value to its own stated value.

iii. Its purchasing power per unit is not maintained at par with that of any other commodity unit. Fiat

money is usually a paper money or credit money.

3. MONO METALLISM :-

When the value of monetary unit is fixed and maintained in terms of one standard metal only, it is

called monometallism. If the standard of money unit is gold the country is said to have a gold

standard. If the unit of money is silver then it will be called silver standard.

4. SILVER STANDARD :-

Under silver standard the monetary unit is given fixed quantity of silver and all other forms of money

are maintained at par by making it convertible into silver at the fixed rate. Silver is allowed to move

freely inside and outside the country.
http://studypoints.blogspot.com/http://studypoints.blogspot.com/http://studypoints.blogspot.com/http://studypoints.blogspot.com/

Methods of Note Issue

Documents

Transcript of Methods of Note Issue