Alternative System of Currency Maximum Limit YouTube Lecture Handouts

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Issue of Currency: Fixed Fiduciary, Maximum Limit, Minimum Reserve, Proportional Reserve | Economics

Alternative System of Currency

The Fixed Fiduciary System

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 limits beyond which there has to be a hundred percent metallic reserve. Over the years, the system was following many other countries. However, the fiduciary limit had to be raised from time to time in order to meet the growing needs of trade and industry.

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. Therefore, this method instills confidence among people as it did when it operated in the U. K. in the past.

Disadvantages

  • Wastage: Firstly, the system appeared to be uneconomical as it locked up a huge quantity of gold unnecessarily.
  • Inelasticity: Secondly, the system proved to be inelastic. Money supply could not be increased easily even when trade and industry expanded.

The Maximum Limit System

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

Advantages

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

Disadvantages

  • Inelasticity: If the upper limit to note issue is fixed at a very low level, the system of such issue suffers from inherent inelasticity. This is likely to create problems in periods of expanding economic activity.
  • Inflation: In contrast, if the limit is fixed at too high a level there is the danger of price inflation — too much money chasing too few goods.

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 from 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 rate may be permitted to fall below the legal minimum.

Advantages

  • Simplicity: The first thing to be said in favour of the proportional reserve system is that it is simple to operate.
  • Elasticity: The second advantage offered by the system is that it is elastic.
  • Disadvantages:
  • Uneconomic nature: 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.
  • Multiplier effect: 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 be in a cumulative deflationary spiral.
  • 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 rule, it seems that the existence of a partial reserve is sufficient to create confidence among the people at large.

Proportional Reserve 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. Such a system was set up in India in 1956.

Advantages

  • Economy: The chief advantage of the system is that it is economy. The reason is that a part of the reserve can be held in the form of (foreign) interest bearing securities.
  • Elasticity: It is highly elastic in nature.
  • Exchange rate stability: Finally, it 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 disadvantage of this system is inflation: The most serious weakness of the system is that it has an inherent inflationary potential. If money supply increases due to inflow of foreign exchange (when the balance of payments position is favorable) but the supply of goods and services, fails to increase proportionately prices will rise and the value of money will fall.

Conclusion: On the balance, it seems that foreign exchange reserves, if judiciously used, can be a source of strength, not weakness, of the monetary system. However, 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 stabilization and reserves held as reserve against notes issued for internal circulation.

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 reserves of gold and foreign currencies. Such a system has been operating in India since 1956.

Advantages

Elasticity and flexibility: The most important advantage of the system 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 development purposes.

India adopted this system for a two-fold reason:

  • To use foreign securities (formerly kept as reserve against note-issue) in order to meet the foreign exchange requirements of the Five Year Plans
  • To facilitate inflationary financing.

Raising resources: 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

  • Inflationary potential: Prima facie, the system is highly dangerous because of its inherent inflationary potential. It breeds inflation by making it quite easy for the government to raise reserves by printing paper currency.
  • Public option: 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 and (4) stability. The emerging trend today in most developing countries is towards the adoption of a reserve system, which is sufficiently flexible to meet their developmental needs.

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