Major Principles of Note Issue | Monetary Policy

There are various principles of issue of currency notes. Two com­mon principles are the banking principle and the current principle. These two principles governed the issue of notes in former times, but at present various other principles have been evolved.

We may well start with the two ancient principles of note issue:

1. The Banking Principle:

It is not at all necessary to establish clear-cut rules and regulations regarding reserve. This is the essence of the banking principle. The banking school argued that, given that bank notes were convertible into gold, there was no need to regulate note issue because the fact of convertibility would prevent any serious over-issue.

Moreover, it was pointless to try to regular the issue of bank notes because the demand for currency would be met by an expansion of bank deposits, which would have the same effect as an expansion of the note issue.

Now like the currency principle the banking principle also has its advan­tage and disadvantages:

Advantages:

The only major advantage of this principle is that the monetary system, based on this principle, would be economic and elastic. There is no need for gold or silver backing to support the issue of currency notes.

Disadvantages:

However, the system would be quite unsafe. Since mone­tary authority can issue money notes at will and without limit, its value is likely to fall in case of over-issue. This, in its turn, is likely to make people lose their confidence in the currency system.

Consequently, there would always remain the danger of a flight from currency at the slightest sign of trouble. This means that in case of a slight loss of confidence (in the event of a fall in the value of currency notes) people would prefer to sell currency notes and demand metallic coins in exchange.

So, the Greham’s Law is likely to operate. Economic history amply demonstrates that the usual tendency of every note issuing authority throughout the world has been to issue notes in excess of requirements, unless checked by law.

2. The Currency Principle:

In contrast with the banking school, the currency school argued that the check offered by convertibility would not operate in time to prevent serious commer­cial disruption. According to this principle, bank notes should be regarded as though they are the gold specie they in fact represent, and consequently the quantity of issue should fluctuate in line with the balance of payments.

According to the former school of thought, notes are not required for their own sake but for use in industry and trade and therefore have to be put into circulation so as to form the basis of credit (apart from acting as a medium of exchange).

However, the note-issuing authority must always guard against the over-issue of notes, in which case there is need to convert notes into coins, what type of money is to be kept as reserve to back the issue of notes so as to meet its demand should be left completely to the discretion of the note-issuing authority.

The currency principle has both advantages and disadvantages:

Advantages:

The only advantage to be secured from the principle is safety. If notes are issued by following this principle the monetary or currency system of the country would be quite safe and would therefore win complete confidence of the people.

Disadvantages:

However, the currency system based on this principle would be wasteful and uneconomic. The reason is easy to find out. Since a huge amount of metal has to be kept as reserve to provide the necessary backing the system would appear to be unproductive and costly, too.

The second disadvantage of the principle is that currency (monetary) system based on gold would inherently inelastic in as much as the volume of notes could be increased or decreased according to the changing require­ments of the country.

Instead the quantity of money in circulation world depend entirely on the existing stock of gold (or any other precious metal) chosen to from the reserve base of the system. If the economy is not at full employment the quantity of money would be grossly inadequate to step up aggregate demand to such a level as to enable the economy achieve full employment.

In other words, in most real life situations of less-than-full employment the stock of money in circulation would be less than what is required to produce the economy’s potential (i.e., full employment) output.

Five Alternative Systems of Note Issue:

In practice, every country has developed its own method of controlling the issue of currency notes. But no country in the world which has gone to the extent of adopting a hundred percent reserve as dictated by the currency principle.

The various systems of note issue prevailing in different countries of the world can be divided into five broad categories.

These are as follows:

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 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.

The system has both merits and drawbacks:

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. in the past.

Disadvantages:

However, this method has several drawbacks:

(i) Wast­age:

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

(ii) Inelasticity:

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

2. The Maximum Limit System:

This system was adopted in France and was in operation upto 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. But any issue of notes beyond the limit was possible only after obtaining necessary legal sanction, i.e., permission from the legislature.

Advantages:

Two advantages of the system are:

(i) 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.

(ii) 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:

Two disadvantages of the system are:

(i) 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.

(ii) 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.

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 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:

Two main advantages of this system are:

(i) Simplicity:

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

(ii) Elasticity:

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

Disadvantages:

The main disadvantages of this system are:

(i) 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.

(ii) 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 be in a cumulative deflationary spiral.

(iii) 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 partial reserve is quite sufficient to create confidence among the people at large.

4. The 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:

Three main advantages are:

(i) 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.

(ii) Elasticity:

It is highly elastic in nature.

(iii) 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 favourable) 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. 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.

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

Advantages:

Two main advantages of this system are:

(i) 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:

(a) 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

(b) to facilitate inflationary financing.

(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:

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.

(ii) 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.