Minimum Reserves System
Under the Minimum Reserve System method of note- issue the central bank has to keep only a minimum amount of reserves, against all the notes issued. This means that any volume of currency can be issued by the central bank depending on the demands of economy. There is no fixed maximum limit under this system. Once a central authority decides a minimum value of reserves the issuing authority is at liberty to expand or contract supply of currency. The reserves are kept in the form of gold and foreign exchange. Usually 20% to 30% of the notes issued are backed by the reserves.
Merits:
(a) Elasticity:
The important merit of this system is elasticity. The state bank can increase or decrease the supply of currency in response to the changes in economic activities.
(b) Responsive:
This system has higher degree of responsiveness than other, systems. This means that if economy demands increase in the supply of currency then under this system appropriate immediate response can be undertaken by the central monetary authorities and supply of currency can be increased according to the requirements of the state of economy.
(c) Safety:
This system enjoys higher degree of safety. The central monetary authorities keep a close eye on the state of affairs of the economy. The notes are issued in response to changes in the market activity and demand for currency
Suitable for Modern World:
This system is widely practised in different modern economies. This system caters to the needs of the growing developed economies. It is also 'suitable for developing economies. The central monetary authorities is ,in a position to manage the supply of currency so as to achieve both short-term and long-term monetary and fiscal targets.
Demerits:
(a) Inconvertibility
The demerit is that - the paper currency under this method is absolutely inconvertible.
(b) No Intrinsic Value:
Major disadvantage is that currency issued under this system has no intrinsic value. This means that the worth of the paper is far less than the value that it claims due to its status of being a legal tender. In simple words, take the example often rupees note in your pocket. The worth of the paper of which the note is made is very low but it claims the purchasing power equivalent to ten rupees just because that it is a legal tender.
Saturday, November 7, 2009
Proportionate Reserve System
Proportionate Reserve System:
Under this system the central bank is required to keep 100% reserves for a particular percentage of notes issued. The rest of the notes issued are backed by Government securities and Government bills. Usually 25% to 40% of notes issued are fully backed by gold and rest are backed by Government securities.
This system remained in force in many countries of the world such as in France, and Germany with 30% and 40% backing respectively.
Merits:
a! A Widely Prevailed System:
This system remained in -force in many parts of the world for different time period. This system is also adopted by United States and UK and many other economically stronger countries. This method ensures a considerable and moderate :rol over supply of currency.
Elastic:
This system is elastic in a sense that if economy is under expansion then naturally there will be a need to expand the.currency and credit. In such situations, central bank will be at case under this system to expand the supply of currency.
;c) High Degree of Safety:
This system is safer and more sound as compared to others. In this system the chances of over-issue of currency are less and so there is less danger of unwanted r nation.
(d) Responsive:
This system has higher degree of responsiveness. This means that if economy demands an increase in the supply of currency then under this system appropriate and .ediate response can be undertaken by the central monetary authorities.
Demerits:
' (a) Rigid:
This system is rigid. As notes cannot be issued over a particular limit without keeping Government securities, so this may lead to rigid supply of currency even when economic and fiscal situation demands expansion in the currency supply.
(b) Contraction in Money Supply::
An other disadvantage is that governments some times have to do unwanted contractions in money supply. This occurs when the gold reserves are diminishing. Then the central bank in such circumstances has to reduce the money supply. This can lead to various adverse effects on the economy provided that the ongoing situation demands expansion in currency supply.
Note: Pakistan also adopted the proportionate reserve system and remained on it till 1965.
Under this system the central bank is required to keep 100% reserves for a particular percentage of notes issued. The rest of the notes issued are backed by Government securities and Government bills. Usually 25% to 40% of notes issued are fully backed by gold and rest are backed by Government securities.
This system remained in force in many countries of the world such as in France, and Germany with 30% and 40% backing respectively.
Merits:
a! A Widely Prevailed System:
This system remained in -force in many parts of the world for different time period. This system is also adopted by United States and UK and many other economically stronger countries. This method ensures a considerable and moderate :rol over supply of currency.
Elastic:
This system is elastic in a sense that if economy is under expansion then naturally there will be a need to expand the.currency and credit. In such situations, central bank will be at case under this system to expand the supply of currency.
;c) High Degree of Safety:
This system is safer and more sound as compared to others. In this system the chances of over-issue of currency are less and so there is less danger of unwanted r nation.
(d) Responsive:
This system has higher degree of responsiveness. This means that if economy demands an increase in the supply of currency then under this system appropriate and .ediate response can be undertaken by the central monetary authorities.
Demerits:
' (a) Rigid:
This system is rigid. As notes cannot be issued over a particular limit without keeping Government securities, so this may lead to rigid supply of currency even when economic and fiscal situation demands expansion in the currency supply.
(b) Contraction in Money Supply::
An other disadvantage is that governments some times have to do unwanted contractions in money supply. This occurs when the gold reserves are diminishing. Then the central bank in such circumstances has to reduce the money supply. This can lead to various adverse effects on the economy provided that the ongoing situation demands expansion in currency supply.
Note: Pakistan also adopted the proportionate reserve system and remained on it till 1965.
Methods of note issue
METHODS OF NOTE ISSUE
Both the principles of note issue have merits and demerits. Based on these principles several systems and methods have been devised for the issuance of notes. These are as follows:
1. Fixed Fiduciary Issue:
This is widely recognised as an important method of note issue. Under tin's system a limit of volume of" currency has been fixed by central authority. This limit is called fiduciary limit. Any note issue in this fiduciary limit is to be backed by Government securities. However any note issued above this limit are to be 100% backed by gold. This system remained in force in many countries of the world at different times.
Following are the merits and demerits of the system:
Merits:
(a) Controlled Supply:
Under this system the supply of currency note can be held under control. The control can be exercised by way of fiduciary limit.
(b) No Danger of Over Issue:
Under this system, as notes issued above a particular limit are to be 100% backed, so there is not a danger of over issue. Any note above fiduciary limit are issued only after keeping 100% metallic reserves.
Demerits:
2 Inelastic:
This system was adopted by England in 1844 but it was subsequently abandoned :r, 1913. The major reasons were that of inelasticity and failure to response towards.the changing economic needs. This means that if economy is rapidly developing then there he increasing demand for the currency and credit. At this moment if required volume of gold is not available than bank will not be able to issue notes. This will produce adverse effects on the economy.
Both the principles of note issue have merits and demerits. Based on these principles several systems and methods have been devised for the issuance of notes. These are as follows:
1. Fixed Fiduciary Issue:
This is widely recognised as an important method of note issue. Under tin's system a limit of volume of" currency has been fixed by central authority. This limit is called fiduciary limit. Any note issue in this fiduciary limit is to be backed by Government securities. However any note issued above this limit are to be 100% backed by gold. This system remained in force in many countries of the world at different times.
Following are the merits and demerits of the system:
Merits:
(a) Controlled Supply:
Under this system the supply of currency note can be held under control. The control can be exercised by way of fiduciary limit.
(b) No Danger of Over Issue:
Under this system, as notes issued above a particular limit are to be 100% backed, so there is not a danger of over issue. Any note above fiduciary limit are issued only after keeping 100% metallic reserves.
Demerits:
2 Inelastic:
This system was adopted by England in 1844 but it was subsequently abandoned :r, 1913. The major reasons were that of inelasticity and failure to response towards.the changing economic needs. This means that if economy is rapidly developing then there he increasing demand for the currency and credit. At this moment if required volume of gold is not available than bank will not be able to issue notes. This will produce adverse effects on the economy.
Banking Principle
BANKING PRINCIPLE
Banking principle lies on the other end. This principle says that note issuance be dealt independently by central bank and it shall be allowed to issue notes to the ongoing circumstances. Also there is no need of full backing of gold ±is principle. Only a percentage of issued note are backed by gold. However all are issued with the guarantee of convertibility into gold.
Elastic Supply:
e principle gives an elastic supply of currency. As there is no restriction of MCS backing of gold, so central bank can issue currency in response to change in •ranomic and monetary situation.
Economical:
This principle is economical in a sense that only a percentage of notes issued are Mated by gold. So the rest of the gold can be used for other purposes.
Usage of Gold Reserves:
This system allows the govt. or issuing authority to make effective and efficient of gold and metallic reserves. As only proportional of notes issued are to be backed So major part of countries' gold reserves can be used to fulfil other economic
rc
Public Confidence:
• i This system also enjoys a good degree of public confidence just like the currency
- - - . People have a good trust on the currency as it has been declared as legal tender i-: issuing authority.
Suitable for Modern Economy:
This principle is suitable for the needs of modern economy. It is flexible and tc and more responsive to change in economic clirhate.
Helpful in Emergency:
This principle is helpful in emergency. This means that in times of need such as wars, or natural disasters govt. can print notes without keeping 100% reserves.
Demerits:
1. Danger of Over Issue:
The danger of over issue always exists in this principle. As no 100% backing is required so there is a tendency towards issuance of notes which may lead to inflation that can be disastrous for the economy.
2. Lack of Convertibility:
As there is no hundred percent backing, so bank failure may occur in a very-unlikely situation if all notes are presented for converting into gold.'However, there is a
very rare chance that such situation appears.
Banking principle lies on the other end. This principle says that note issuance be dealt independently by central bank and it shall be allowed to issue notes to the ongoing circumstances. Also there is no need of full backing of gold ±is principle. Only a percentage of issued note are backed by gold. However all are issued with the guarantee of convertibility into gold.
Elastic Supply:
e principle gives an elastic supply of currency. As there is no restriction of MCS backing of gold, so central bank can issue currency in response to change in •ranomic and monetary situation.
Economical:
This principle is economical in a sense that only a percentage of notes issued are Mated by gold. So the rest of the gold can be used for other purposes.
Usage of Gold Reserves:
This system allows the govt. or issuing authority to make effective and efficient of gold and metallic reserves. As only proportional of notes issued are to be backed So major part of countries' gold reserves can be used to fulfil other economic
rc
Public Confidence:
• i This system also enjoys a good degree of public confidence just like the currency
- - - . People have a good trust on the currency as it has been declared as legal tender i-: issuing authority.
Suitable for Modern Economy:
This principle is suitable for the needs of modern economy. It is flexible and tc and more responsive to change in economic clirhate.
Helpful in Emergency:
This principle is helpful in emergency. This means that in times of need such as wars, or natural disasters govt. can print notes without keeping 100% reserves.
Demerits:
1. Danger of Over Issue:
The danger of over issue always exists in this principle. As no 100% backing is required so there is a tendency towards issuance of notes which may lead to inflation that can be disastrous for the economy.
2. Lack of Convertibility:
As there is no hundred percent backing, so bank failure may occur in a very-unlikely situation if all notes are presented for converting into gold.'However, there is a
very rare chance that such situation appears.
Principles and Methods of money Issue
Principles and Methods of Note Issue
At the time of Bank Chartered Act in England in 1844 there was a huge
controversy over the matter as to what is the most suitable method and principle of issuing notes. Some economists favour the currency principle and other advocate for banking principle. Both these principles are discussed below:
CURRENCY PRINCIPLE
Theory:
The currency principle is based on 100% gold backing. According to this principle Central Bank must keep 100% reserves against each and every note issued. So there will be full convertibility under such system.
Merits:
1. Full Safety:
This principle is 100% safe as there is 100% backing. So Central Bank is able to convert any number of notes into equivalent reserves of gold. So there will be full safety and there will be no danger or fear of bank runs and panics.
2. No over issue:
The system will restrict the central authority from over issuing notes. Hence there will be an effective control over inflation.
3. Stability:
The 100% backing gives an element of stability to this system. The value of the currency remains stable and it enjoys a greater degree of public confidence.
4. Confidence:
As already stated the currency issued under this principle enjoys a complete confidence of public.
Demerits;
Following are the demerits of this principle: 1. Inelastic:
This system is highly inelastic and rigid. As 100% backing is required so when
gold reserves are not available central bank cannot issue nc. though the this book.
No Use of Gold:
Further this system makes an inefficient use of gold. Tons of gold is stored in and no effective use is made of it.
ot Suitable for Modern Economy:
he currency principle is not suitable for modern economy. It can not be y used in today's complex economic situation which changes very rapidly.
At the time of Bank Chartered Act in England in 1844 there was a huge
controversy over the matter as to what is the most suitable method and principle of issuing notes. Some economists favour the currency principle and other advocate for banking principle. Both these principles are discussed below:
CURRENCY PRINCIPLE
Theory:
The currency principle is based on 100% gold backing. According to this principle Central Bank must keep 100% reserves against each and every note issued. So there will be full convertibility under such system.
Merits:
1. Full Safety:
This principle is 100% safe as there is 100% backing. So Central Bank is able to convert any number of notes into equivalent reserves of gold. So there will be full safety and there will be no danger or fear of bank runs and panics.
2. No over issue:
The system will restrict the central authority from over issuing notes. Hence there will be an effective control over inflation.
3. Stability:
The 100% backing gives an element of stability to this system. The value of the currency remains stable and it enjoys a greater degree of public confidence.
4. Confidence:
As already stated the currency issued under this principle enjoys a complete confidence of public.
Demerits;
Following are the demerits of this principle: 1. Inelastic:
This system is highly inelastic and rigid. As 100% backing is required so when
gold reserves are not available central bank cannot issue nc. though the this book.
No Use of Gold:
Further this system makes an inefficient use of gold. Tons of gold is stored in and no effective use is made of it.
ot Suitable for Modern Economy:
he currency principle is not suitable for modern economy. It can not be y used in today's complex economic situation which changes very rapidly.
Banking 2010
Besides these forms, money can be classified into several other less important us. These include the following:
i a) Black Money: Black money is one which has been gathered through illegal means. All the wealth obtained through prohibited ways such as gambling, smuggling, crime, robbery etc can be called black money. An important characteristic of the black money is that it is not reported in the calculation of GDP or NI. These are unreported activities and form part of underground economy.
(b) White Money: White money is one which has been earned through legal and legitimate means. The holding of such a money is justifiable .on social, moral, legal and equity basis. Such a money is not merely a wealth but it has satisfaction, content, happiness, associated with it.
Cheap Money: Cheap money is one whose cost of borrowing is less than the standard rate of interest. In times of recessions banks are willing to lend money at a lower rate of interest that generally prevails in the economy. Such a money is called cheap money.
Dear money: In times of boom there is a high demand for money. To control it banks iy increase the interest rate above normal level. The cost of borrowing the money
ir.cn increases. Such a money is called the dear money.
important Note:
Under advantages of metallic money it is written that it can't be hoarded or
xeited. This means that if the value of content of coin is greater than its face value, then
people will melt it into metal block to take advantage of its high intrinsic value. To
understand this suppose government issue coins of 1 rupee. Further suppose thai [hey are
made up of! gm silver. This means the coin that is made up of ! gm silver has face value I rupee but intrinsic (internal) value of 1 gm silver ( Suppo>c 1 gm silver is equal to 5 :s) this will induce people to collect such coins, melt them in ordinary metal blocks •II them for Rs. 5 each. It's result will be that very soon coins will disappear from the
nirket and there will be liquidity problem.
i a) Black Money: Black money is one which has been gathered through illegal means. All the wealth obtained through prohibited ways such as gambling, smuggling, crime, robbery etc can be called black money. An important characteristic of the black money is that it is not reported in the calculation of GDP or NI. These are unreported activities and form part of underground economy.
(b) White Money: White money is one which has been earned through legal and legitimate means. The holding of such a money is justifiable .on social, moral, legal and equity basis. Such a money is not merely a wealth but it has satisfaction, content, happiness, associated with it.
Cheap Money: Cheap money is one whose cost of borrowing is less than the standard rate of interest. In times of recessions banks are willing to lend money at a lower rate of interest that generally prevails in the economy. Such a money is called cheap money.
Dear money: In times of boom there is a high demand for money. To control it banks iy increase the interest rate above normal level. The cost of borrowing the money
ir.cn increases. Such a money is called the dear money.
important Note:
Under advantages of metallic money it is written that it can't be hoarded or
xeited. This means that if the value of content of coin is greater than its face value, then
people will melt it into metal block to take advantage of its high intrinsic value. To
understand this suppose government issue coins of 1 rupee. Further suppose thai [hey are
made up of! gm silver. This means the coin that is made up of ! gm silver has face value I rupee but intrinsic (internal) value of 1 gm silver ( Suppo>c 1 gm silver is equal to 5 :s) this will induce people to collect such coins, melt them in ordinary metal blocks •II them for Rs. 5 each. It's result will be that very soon coins will disappear from the
nirket and there will be liquidity problem.
Banking
This means that if you take this note to the bank asking for conversion the bar. compelled to give you 100 rupees in any denomination. The value of the paper content of 100 rupee note is extremely low (almost nil) yet it commands purchasing power worth of 100 rupees. This is because of the fact that it has been declared as legal tender by the government and is generally accepted as a medium of exchange.
Bank Money:
Bank money means near money, which is not always legal tender but it is wi. accepted as a medium of exchange. (The meanings and importance of near money has been described in next question). Here what needs to be stressed is that near money is an important type of money in the modern economy and much of the business of world takes place in near money. Bank money mostly consists of cheques, drafts and bills of exchanges. These are briefly described below:-
(a) Cheque:
A cheque is a written instruction on a specified piece of paper from a client to h;s bank, instructing the later to pay a certain sum of money. The cheque would be "self i.e.. money is withdrawn by the client himself or it could be in the name of any third part> There are three kinds of cheques, these include bearer cheques, crossed cheques and order cheques (these are described in credit instrument section.)
(b) Bill of Exchange:
Bill of exchange is a convenient way to pay for commercial transaction in credit. The seller instead of taking cash from the buyer draws a bill on him which the bu>e: accepts by signing it. This bill can be a sight bill or a time bill. In case of sight bill the payment is made on demand and in case of time bill the payment is due after a particular time period.
(c) Draft:
Draft is just like a cheque. However, the difference is that it is drawn by a bank on its own branch or on any other bank's branch. So we can say that drafts are the cheque which are used by banks. A draft when drawn on a bank, directs it to pay a certain sum of money to a person named on it.
These are the four types of money. Besides these the fifth type which is rapidly gaining both the importance and the usage in the modern sophisticated world is called plastic money.
Plastic Money:
Plastic money means the credit cards and plastic cards which have silicon chips and a specially printed set of characters. These cards are used for making payments at -rdinary shops and at EFTPOS (Electronic Funds Transfer at Point of Sale).
The plastic money, smart cards and credit cards are described in the last section of this book .
Bank Money:
Bank money means near money, which is not always legal tender but it is wi. accepted as a medium of exchange. (The meanings and importance of near money has been described in next question). Here what needs to be stressed is that near money is an important type of money in the modern economy and much of the business of world takes place in near money. Bank money mostly consists of cheques, drafts and bills of exchanges. These are briefly described below:-
(a) Cheque:
A cheque is a written instruction on a specified piece of paper from a client to h;s bank, instructing the later to pay a certain sum of money. The cheque would be "self i.e.. money is withdrawn by the client himself or it could be in the name of any third part> There are three kinds of cheques, these include bearer cheques, crossed cheques and order cheques (these are described in credit instrument section.)
(b) Bill of Exchange:
Bill of exchange is a convenient way to pay for commercial transaction in credit. The seller instead of taking cash from the buyer draws a bill on him which the bu>e: accepts by signing it. This bill can be a sight bill or a time bill. In case of sight bill the payment is made on demand and in case of time bill the payment is due after a particular time period.
(c) Draft:
Draft is just like a cheque. However, the difference is that it is drawn by a bank on its own branch or on any other bank's branch. So we can say that drafts are the cheque which are used by banks. A draft when drawn on a bank, directs it to pay a certain sum of money to a person named on it.
These are the four types of money. Besides these the fifth type which is rapidly gaining both the importance and the usage in the modern sophisticated world is called plastic money.
Plastic Money:
Plastic money means the credit cards and plastic cards which have silicon chips and a specially printed set of characters. These cards are used for making payments at -rdinary shops and at EFTPOS (Electronic Funds Transfer at Point of Sale).
The plastic money, smart cards and credit cards are described in the last section of this book .
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