Methods for Note Issues in India - Indian Financial System, Indian Financial System B Com Notes | EduRev

Indian Financial System

Created by: Arshit Thakur

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The following points highlight the five alternative systems of currency note issue. 

System # 1. The Fixed Fiduciary System:

This is one of the oldest systems of con­trolling note-issues. Under this system, a country can issue a certain quantity of notes without any reserve, i. e., without gold or silver backing.

The upper limit to this quantity is called fiduciary limit beyond which there has to be a hundred percent metallic reserve. Over the years the system was followed by more and more countries. However, the fiduciary limit had to be raised from time to time in order to meet the growing needs of trade and industry. The system has both advan­tages and disadvantages.

Advantages:

This method enables the central bank to exercise strict control over note issue which is important for controlling inflation or main­taining stability in the value of a currency. So this method instills confidence among people as it did when it operated in the U.K.

Disadvantages:

However, this method creates two main prob­lems:

1. Wastage:

Firstly, the system appeared to be uneconomical as it locked up a huge quan­tity of gold unnecessarily

2. Inelasticity:

Secondly, the system proved to be inelastic. Money supply could not be increased easily even when trade and industry expanded.

System # 2. The Maximum Limit System:

This system was adopted in France and was in operation up to 1928-(just a year before the great world trade depression of 1929). Under the system, the State fixed an upper limit to note-issue without any reserve. But any issue of notes beyond the limit was possible only after obtaining necessary legal sanction, i.e., permission from the legislative body.

Advantages:

Two advantages of the Maximum Limit Sys­tem are:

1. Freedom:

The most important thing to be said in favour of the system is that under it the note-issuing authority enjoys complete free­dom (or full discretion) as regards reserves.

2. Economy:

Secondly, the system is eco­nomical in the sense that the reserve of gold kept in an unproductive form can be reduced to a minimum.

Disadvantages:

Two disadvantages of the system are:

1. Inelasticity:

However, if the upper limit is fixed at a very low level the system of note- issue suffers from inherent inelasticity. This is likely to create problems in periods of ex­panding economic activity.

2. Inflation:

In contrast, if the limit is fixed at too high a level there is the danger of price inflation, of too much money chasing too few goods?

System # 3. The Proportional (Fractional) Reserve System:

Most countries of the world have now adop­ted the fractional reserve system. Under this system, note issue is conditioned by gold bac­king (varying between 25 to 40%). This means that a certain portion of note-issue has to be backed by gold reserve.

The remaining part of the note issue has to be covered by government securities (which are highly liquid assets) and approved commercial papers. There is also the general provision that — subject to certain conditions and penalties — the reserve ratio may be permitted to fall below the legal minimum.

Advantages:

Two main advantages of the system are the following:

1. Simplicity:

The first thing to be said in favour of the proportional reserve system is that it is simple to operate.

2. Elasticity:

The second advantage offered by the system is that it is elastic.

Disadvantages:

Three disadvantages of the method are:

1. Uneconomic:

The most important defect of the system is that it is not economical. The reason is that an unproductive gold reserve has to be kept.

2. Multiplier effect:

Secondly, the system creates reverse multiplier effect. In the event of a fall in the central bank’s stock of gold, the note-issue contracts more than in proportion. This is likely to have contractionary effects on trade and industry. At the end the economy is likely to suffer from depression and unem­ployment.

3. Inadequacy:

Finally, the system proves to be useless in times of financial crisis because the gold reserve is considerably less than the total note-issue. If people lose con­fidence in currency notes in times of crisis, the reserve becomes grossly inadequate to liquidate all the notes.

If the system is able to generate confidence among people, the reserve is unnecessary. However, as a general rule, it seems that the existence of a proportional reserve is quite sufficient to create confidence among the people at large.

System # 4. The Proportional Reserve System not Based on Gold:

In most developing countries like India there is, no doubt, a legal provision for maintaining a certain percentage of note-issue in the form of reserve, which can be held partly in gold and partly in foreign currencies.

Advantages:

Three main advantages of the method are:

(i) Economy:

The chief advantage of the system is that it is economic. The reason is that a part of the reserve can be held in the form of (foreign) interest-bearing securities.

(ii) Elasticity:

It is highly elastic in nature.

(iii) Exchange rate stability:

Finally, the system enables the central bank to maintain stability in the external value of the country’s currency. When, for instance, a country suffers from a deficit in the balance of payments the external value of its currency tends to fall.

This can be prevented by selling foreign currencies. In contrast, when a country enjoys a surplus in its balance of payments, the external value of the country’s currency tends to rise. In such a situation the rate of ex­change can be kept steady by purchasing foreign currencies.

Disadvantages:

The main disadvantage of the method is:

Inflation:

This system has an inherent in­flationary potential. If money supply increases due to inflow of foreign exchange (when the balance of payments position is favourable) but the supply of goods and services fails to increase proportionately, prices will rise and the value of money will fall.

On balance, it seems that foreign exchange reserves, if judiciously used, can be a source of strength, not weakness, of the monetary system. But it is not always proper to hold the foreign balance as part of the legal reserve against note issue. It is necessary to draw a distinction between reserves held for ex­change rate stabilisation and reserves held as reserve against notes issued for internal circu­lation.

System # 5. The Minimum Reserve System:

Finally, we may refer to the minimum reserve system under which the central bank can issue notes without limit against government securities and approved commercial papers but is under the legal obligation to keep a minimum reserve of gold and foreign curren­cies. Such a system was adopted in India in 1956.

Advantages:

Two advantages of the system are:

(i) Elasticity and flexibility:

The most impor­tant advantage of the system is that it imparts a high degree of elasticity and flexibility to the system of note-issue. The power to issue notes can be used for deficit spending if and when it is needed for developmental purposes.

India adopted this system for a twofold reason:

(i) To use foreign securities (formerly kept as reserve against note-issue) in order to meet the foreign exchange requirements of the Five Year Plans and

(ii) To facilitate deficit financing (spending).

(ii) Raising resources:

Secondly, the mini­mum reserve system is particularly suitable for developing countries like India which have relied on the planning system for achie­ving faster economic growth. The need to raise resources to finance the plans is much more important in such countries than keeping a huge amount of unproductive reserves with the central bank.

Disadvantages:

Two disadvantages of the system are:

(i) Inflationary potential:

Firstly, the system is highly dangerous because of its inherent inflationary potential. It breeds inflation by making it quite easy for the government to raise resources by printing paper currency.

(ii) Public Opinion:

Secondly, the system completely ignores the role of currency reserves in maintaining people’s confidence in the monetary system of the country. Critics point out that the system will prove to be successful only under a strong government (free from corruption) which is determined to follow a sound economic policy and is successful in tilting public opinion in its favour.

Conclusion:

It is very difficult to say which of the above systems of regulating note issue is the best. It all depends on the particular economic circums­tances of the country concerned.

An ideal system is one which seeks to secure four major objectives:

(1) Economy
(2) Elasticity
(3) Safety
(4) Stability

The emerging trend today in most developing countries is toward the adoption of a reserve system which is sufficiently flexible to meet their develop­mental needs.

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