MONETARY SYSTEM

MONETARY STANDARD

• It refers to the type of standard money used in an economy. The standard money, of course, is that legal money in which the government of the country itself discharges its obligations.

• It refers to the overall set of laws and practices which control the quality and quantity of money in a country. The standard money of a country which determines and regulates the exchange value of goods and services.

MONETARY STANDARD

METALLIC STANDARD

MONO

SILVER STANDARD

GOLD

STANDARDD

IRECT

GOLD COIN STANDARD

GOLD BULLION STANDARD

GOLD EXCHANGE STANDARD

INDIRECT

GOLD RESERVE STANDARD

GOLD PARITY STANDARD

BIMETALLISM(Gold & Silver)

PAPER CURRENCY STANDARD

FREEE MANAGED

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 metal.

Metallic standard may be of two types:

• Monometallism

• Bimetallism

MONOMETALLISM

Monetary unit is made up or convertible to only one metal. Only one metal is used as standard money whose market value is fixed in terms of a given quantity and quality of the metal.

MONOMETALLISMMerits: • Simplicity: Since only one metal is used as a standard of value,

Monometallism is simple to operate and easy to understand.

• Public Confidence: The standard money is made of a precious metal, it inspires public confidence.

• Promotes Foreign Trade: It facilitates and promotes foreign trade. Gold or silver standard is easily acceptable as an international means of payment.

• Avoids Gresham’s Law: It avoids the operation of Gresham’ 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.

• 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.

MONOMETALLISM

Demerits:

• Costly Standard: It is a costly standard and all countries, particularly poor countries cannot afford to adopt it.

• Lacks Elasticity: Money supply depends upon the metallic reserves. Thus, the money supply cannot be changed in accordance with the requirements of the economy.

• Retards Economic Growth: Economic growth requires expansion of money supply to meet the increasing needs of the economy. But, scarcity of metal may create scarcity of money supply which, in turn, may hinder economic growth.

• Lacks Price Stability: Since the price of the metal cannot remain perfectly stable, the value of money lacks stability.

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 fitness in terms 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 fitness11/12.

The coinage of the Rupee was free and people can get their silver converted into coins at the mint. Similarly, 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 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.

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 fitness 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. It was also to abandon this standard in 1931.

Germany adopted the gold standard in 1873, France in 1878 and the USA in 1900.

Gradually, gold standard disappeared from different countries and finally it was completely abandoned by the world by 1936.

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 nation’s money are kept at constant value in terms of gold and also in terms of silver”.

Two metallic standards operate simultaneously. Two types of standard coins from two different metals are minted. Both the types of standard coins become unlimited legal tender.

FEATURES OF BIMETALLISM

• The standard is based on two metals, it is the simultaneous maintenance of both gold and silver standards.

• There is free and unlimited coinage of both metals.

• The mint ratio of the values of gold and silver at the mint is fixed by the government.

• The face value and the intrinsic value of both the coins are equal.

• There is free import and export of both the metals.

• Both the coins are unlimited legal tenders. They are also convertible into each other.

MERITS • Convenient full-bodied currency: It 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.

• Price Stability: Under this 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.

• Exchange rate stability: As long as gold and silver are stabilized 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.

• Sufficient money supply: 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.

• Maintenance of bank reserves: 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.

• Low interest rates: Under this standard, 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.

• Stimulates foreign trade: It 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 import and export due to the free inflow of both types of coins.

DEMERITS • Operations 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 overvalued 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 will remain in practice.

• 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.

• Payment difficulties: Bimetallism leads to difficult situation in the settlement of transactions when one party insists on payment in terms of particular type of coins.

• Encourages speculative activity: It encourages speculative activity in the two metals when their prices fluctuate in the market.

• 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.

• Costly monetary standard: Bimetallism is a costly monetary standard and all nations, particularly the poor nations, cannot afford to adopt it.

GOLD STANDARD

It refers to a monetary system in which the value of monetary unit or standard currency of the country is directly formed or linked with gold.

According to 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 an equality with one another ”

According to Coulborn, “the gold standard is an arrangement where by the chief piece of money of a country is exchangeable with a fixed quantity of gold of a specific quality”.

FEATURES OF GOLD STANDARD

• Definition of standard money in terms of gold.

• Gold coins are unlimited legal tender.

• No restriction on import-export of gold.

• Free and unlimited coinage of gold.

• Free and unlimited melting of gold.

• All other types of money (paper money) are freely convertible into gold or equivalent of gold.

TYPES OF GOLD STANDARD

• Gold Coin standard

• Gold bullion standard

• Gold exchange standard

• Gold reserve standard

• Gold parity standard

GOLD COIN STANDARD

The gold coin or currency standard or the gold specie standard is the oldest form of gold standard. It is regarded as the traditional form of gold standard. This standard was prevalent in U.K, France, Germany and U.S.A before the World War I.

It was a pure form of gold standard, as full-bodied standard coins made of gold were circulated under this system. Token coins and other forms of money were to be redeemable into gold.

FEATURES

• Monetary unit is defined in terms of gold.

• Coinage is unlimited and free of cost.

• Other forms of money are also in circulation and are convertible into gold.

• Free and unlimited melting of gold coins.

• Free import and export of gold.

• Gold is unlimited legal tender for all types of payments. All values are expressed in terms of gold.

• Govt. buys and sells gold at fixed prices and thereby maintains parity between the face value and intrinsic value of the standard coin.

MERITS

• It enjoys full confidence of the public, as the standard coins are made of gold and it is universally acceptable.

• Free and unrestricted import-export of gold ensures stability in foreign exchange rates. This promotes international trade.

• It is automatic working and needs no govt. intervention. Money supply depends upon the volume of gold reserve and money supply can be changed in accordance with the changes in the volume of gold reserves.

• This is the simplest form of gold standard which can be easily understood by the common people.

DEMERITS

• It is fair-weather standard. It operates smoothly during peace time but fails to work properly and to inspire public confidence at the time of economic crisis.

• There is a great problem of wastage of gold. Circulation of gold coins suffer depreciation.

• Internal price stability is unreal. Various factors like discoveries of new gold mines, changes in the techniques of production of gold, changes in imports and exports of gold, lead to changes in the price of gold, hence cause fluctuations in the internal prices.

GOLD BULLION STANDARD

It was adopted by Great Britain in 1925.

Gold Bullion standard is a modified version of gold coin standard in which there was no gold coinage and currency is convertible into gold bullion (i.e. gold bars)

FEATURES• Gold coins are not in circulation. The standard currency unit

is expressed in terms of a definite quantity of gold of a given fineness. Gold does not act as a medium of exchange, but it remains a measure of value.

• Coinage of gold is not allowed, i.e. people cannot get their gold converted into coins at the mint.

• Other forms of money are not fully backed by gold reserves. But the govt. guarantees full convertibility of currency into gold bullion.

• The govt. is always ready to buy and sell gold at fixed prices.

• There are no restriction on import and export of gold.

• Since govt. is always ready to convert token and paper money into gold at fixed price, it inspires public confidence.

MERITS• The standard is easy to understand and economical in

functioning.

• As the gold coins are not in circulation, there is no wastage of the precious metal. And there is no 100% backing of note issue.

• Since the currency is not fully convertible, the monetary authority can expand adequate money supply by a small increase in gold reserves.

• Gold bullion standard operates automatically. If demand for money falls people will start buying gold from the govt. As a result, gold reserves, thus the money supply, will fall. In this way equilibrium in the demand and supply of money will be established.

DEMERITS

• This standard fails to work at the times of economic crisis. It looses public confidence during war periods when the demand for gold increases and the govt. reserves are not sufficient to meet this demand.

• It is a managed currency system, as the govt. manages token money, paper money and gold reserves. Without govt. intervention, this standard cannot function properly.

• Under this system, enough gold reserves are kept. They remain idle and cannot be put to productive uses.

• Compared to gold coin standard, this standard inspires less public confidence because gold coins are not in circulation. The currency is generally converted into gold for foreign exchange purpose and not for domestic purpose.

GOLD EXCHANGE STANDARDIt refers to a system in which there is neither a gold currency in circulation not gold reserve held for external purposes. The domestic currency of a country is not converted into gold for meeting internal needs, but is converted into the currency of some foreign countries. The external value of the domestic currency unit is determined in terms of the foreign currency.

The domestic currency has no direct link with gold. It is linked at a fixed exchange rate with the currency of another country which is convertible into gold.

In addition to gold reserves, the monetary authority of the country maintains sufficient amount of foreign exchange reserves for making international payments.

FEATURES • The domestic currency is made of token coins and paper money.

• The domestic currency is not convertible into gold but is convertible at the fixed rate into the currency of the other country based on the gold standard.

• There is no direct link between the volume of domestic currency and the gold reserves.

• Foreign exchange and foreign bills along with gold constitutes the reserve base of the country.

• There is no free import and export of gold. It is regulated and controlled by the govt.

• Foreign payments are made either in gold or in currency based on gold.

• Gold is used neither as a medium of exchange nor as a measure of value. But prices of all goods and services are indirectly determined by the price of gold.

MERITS

• As the domestic currency is not backed by gold reserves, the monetary authority can easily expand money supply to meet the increasing needs of trade and industry.

• It avoids the wastage of gold because of non-circulation of gold coins.

• All the advantages of the gold standard become available under this standard without putting gold coins in circulation.

• The govt. of the country earns interest on the reserves kept in the foreign country.

• This standard is particularly suited to the less developed countries with gold scarcity.

DEMERITS

• The standard is complex in its working and is not easily understandable by the common people.

• As the domestic currency is not directly linked with gold and the currency is not convertible into gold, it does not inspire much public confidence.

• This standard does not work automatically and needs active govt. intervention. It is called a managed standard.

• Money supply can be increased easily but it is very difficult to reduce money supply. Hence leads to inflation.

• This system is not economical. To make it work, the govt. has to keep many reserves which involve lot of expenditure.

• As the domestic currency of the country is linked with the foreign currency, the insecurity and instability of the foreign currency makes the monetary system of the related country insecure and unstable.

GOLD RESERVE STANDARD

The monetary system adopted by Great Britain, USA, France in 1936 and later Holland, Belgium and Switzerland under this agreement is called GRS.

Free flow of gold or foreign currency was allowed to stabilize exchange rates and promote foreign trade without affecting the internal value of the domestic currency.

FEATURES• No link with gold

• Restrictions on import-export of gold

• Establishment of exchange equalization fund by participating countries to maintain stability in exchange rates. For this purpose, the fund comprises local currency, foreign exchange and gold. If the demand for a foreign currency rises, the fund will increase the supply of that foreign currency in the open market and thus will prevent any rise in the value of that currency in terms of other currencies.

• The composition and movement of reserves of the Exchange Equalization Fund are kept strictly confidential from the public.

• Exchange rate stability is achieved without disturbing the internal economy of the member country

GOLD PARITY STANDARD

• The Gold Parity Standard is one of the form of Gold Standard.

• The Gold Parity Standard is the modern version of International Gold Standard. It is the outcome of establishment of IMF in 1946.

• Every member country of the International Monetary Fund declare the value of its money unit in terms of a defined quantity of gold.

• The standard aims at maintaining stable exchange rates without interfering into the domestic monetary system of the member countries.

FEATURES• The Par Value of Currency is defined in terms of Gold.

• Stability of internal price level is not necessitated by this standard.

• It permits reasonable flexibility in exchange rates as alteration in par value, under the regulation of IMF are allowed to the member countries.

• Local Currency has not linked with Gold: Under this system gold is neither a medium of exchange nor a standard of value gold doesn’t circulate in the country. Under this system local currency consists of token coins made of cheaper metals and paper currencies.

•Definition of money in terms of Gold: Under this system it is obligatory on the part of every member country of the I.M.F. to define the par value of the money in terms of gold.

• Every Member country follows on independent monetary policy: Every member country of the IMF enjoys complete freedom in its internal monetary affairs. The monetary policy of a country has neither any direct nor any indirect relationship with the monetary policy of another country.

•Provision of loan by the IMF: Under this system the IMF Extends loan in foreign currencies to the member countries to help maintain stability in foreign exchange rates.

RULES OF GOLD STANDARDGeneral Principles for the successful working of the international gold standard:

• It should involve a common agreement among nations as to the objective for which it existed.

• It should bring stability of prices and guarantee stability of exchange.

• Individual central banks should avoid such actions which might endanger stability of prices through their effects on the policy of other central banks.

Rules for the smooth working of Gold Standard: • Free and unrestricted export and import of gold between countries.

• The country importing gold should expand credit within the country and the gold exporting country should contract credit.

• Gold value of the domestic currency was to be kept stable. It should not be overvalued or undervalued.

• Gold standard countries should make efforts to avoid international indebtedness. When external debt increase, the country should increase exports to pay back the interest and principal.

• There should be free movement of goods and services among the gold standard countries. Under gold standard, differences in prices between countries are expressed through excess of exports or imports of one country over the other and the excess of exports or imports are adjusted through inflow or outflow of gold. Thus, restriction on import or export of goods disturbs the automatic working of the gold standard.

• Availability of sufficient gold reserves and their proper distribution among the participating countries is essential for the successful working of the gold standard.

DOWNFALL OF THE GOLD STANDARDFollowing are the main reasons for the decline of gold standard :

• Violation of Rules of gold standard like free movement of gold between countries, automatic expansion and contraction of currency and credit with inflow and outflow of gold, etc.

• The successful working of gold standard requires free and uninterrupted trade of goods between countries. But during interwar period, most of the countries under gold standard adopted restrictive policies regarding imports. This resulted in the reduction in international trade and thus the breakdown of the gold standard.

• Economic co-operation among the participating countries is necessary for the success of gold standard. After World War I, there was a complete absence of such co-operation among the gold standard countries, which led to the downfall of the gold standard.

• Political instability among the European countries was responsible for the failure of gold standard. Factors like rumors of war, revolutions, fear of transfer of funds to other countries threatened the safe working of the gold standard.

• A necessary condition for the success of gold standard is the availability of adequate gold stocks and their proper distribution among member countries. But in the inter war period, countries like USA and France accumulated too much of gold, while countries of Eastern Europe and Germany had very low stock of gold. Shortage of gold reserve led to the abandonment of gold standard.

• Smooth working of gold standard requires that gold should be used for trade purposes and not for the movement of capital. But during inter war period, excessive international indebtedness led to the decline of gold standard. Reasons for excessive movement of capital are: plenty of borrowing by the underdeveloped countries from the advanced countries for investment purpose, Germany forced to pay war reparation in gold, movement of large amount of short term capital from one country to another in search of security, etc.

• The world wide depression of 1929 -33 (Great Depression) gave the final blow to the gold standard. Falling prices and wide-spread unemployment were the fundamental features of depression which forced the countries to impose high tariffs to restrict imports and thus international trade.