Different methods of note issues. There was at one time a controversy whether notes should be issued on the currency principle (i.e., 100 per cent reserve) or banking principle, leaving the question of paper currency reserve entirely to the discretion of the banks of issue.
Different methods of note issues
There was at one time a controversy whether notes should be issued on the currency principle (i.e., 100 per cent reserve) or banking principle, leaving the question of paper currency reserve entirely to the discretion of the banks of issue. The Currency Principle provides safety it lacks elasticity, whereas the Banking Principle ensures elasticity but is wanting in security. A sound system of note-issue, however, must have both elasticity and safety. Hence, all countries have evolved systems each of which represents a compromise between these two principles. Among these we may mention:
(a) Fixed Fiduciary Principle or Partial Deposit System;
(b) Proportional Reserve System; and
(c) Fixed Minimum Reserve System.
Fixed Fiduciary System: In Great Britain he fixed fiduciary system was embodied in the Bank Charter Act of 1844 as amended subsequently. Under this system, a given quantity of notes can be issued by the central bank without keeping any metallic reserves. This portion could be covered only by Government securities. This is called the fiduciary limn. Notes issued in excess of the fiduciary limit must be covered pound for pound by gold.
This method was attacked from time to time as lacking in elasticity. It, however, acted as a brake on over-expansion of credit. In abnormal circumstances, the fiduciary limit could be raised by mending the Act. In 1928, the Treasury was given power to increase the fiduciary limit beyond the legal ceiling. This gave some elasticity to the system. It was, however, objected that the raising of the fiduciary limit was always interpreted as a sign of weakness. Thus, it was held that elasticity was imparted but there was loss of confidence. In spite of criticism, the -system has survived owing, mainly perhaps, to the force of tradition, Japan and Norway, and since 1957, India too, have introduced the same system.
Proportional Reserve System: This system has been adopted on the European continent, France keeping 35 per cent and Germany 40 per cent reserve. With some modification, it has also been followed by the Federal Reserve System of the U.S.A.
It should be borne in mind that the central bank reserve is not merely intended as a cover for notes issued. "The amount of international currency a country needs does not depend at all closely on the amount of its domestic currency and credit; it depends on its liability to suffer fluctuations in the balance of external payments." And what is kept as 'cover' is not available for external settlements.
This system is more elastic than the Fixed Fiduciary Principle. In fact, note-issue by a central bank is slightly better from this point of view, since there may be some resistance by the central bank to the proposals of the government to use the method of printing additional notes for its finance.
System in India: So far as India is concerned, the Reserve Bank of India has the monopoly of note-issue. For this purpose, the Reserve Bank, like some other central banks (e.g., the Bank of England), maintains a separate department called the Issue Department. The assets of this department are kepi distinct from those of the other department of the Bank, the Banking Department.
Till 1956, the Reserve Bank of India issued notes on the basis of the proportional reserve system. The assets of the Issue Department consisted of silver, rupee coins, Government of India (rupee) securities, gold coins, gold bullions or foreign sterling securities provided that the amount of gold coin and gold bullion was not at any time less than 40 crores in the value and gold bullion and sterling securities must be at least 40 % of the total reserve. With the sanction of the Central Government, the 40 per cent limit could be reduced for limited periods on payment of a special tax on the deficiency. Thus, the system adopted in India was a compromise between the two systems discussed above.
Fixed Minimum Reserve System: However, in 1956, the proportional reserve system was replaced by a fixed minimum reserve. A minimum holding of foreign securities worth Rs. 400 crores and of gold worth Rs. 115 crores was prescribed. In 1957 it was cut down to Rs. 200 crores including gold worth at least Rs. 115 crores. This drastic, reduction was necessitated by the rapid depletion of foreign exchange reserves due to adverse balance of payments.
Under the system of note-issue, paper currency in India has now become practically inconvertible.