Methods of Note Issue

Both the principles of, note issue mentioned above, have serious defects. The monetary experts’
by coordinating the advantages of both the principles have evolved various systems or methods
of notes issue. The main systems of note issue prevalent in different countries of the world are
(1) Partial Fiduciary System. (2) Proportional Reserve System. (3) Minimum Reserve System.
These systems are now discussed in brief.

(1) Fixed Fiduciary System. Under this system, a fixed amount is laid down by law which need
to be covered by government securities. Notes issued in excess of this amount must be fully
backed by gold. England adopted this system in 1844. The ‘system lacked elasticity and was not
capable of satisfying the needs of trade and industry. This system was abandoned in 1913 in
favour of proportional reserve system.

(2) Proportional Reserve System. Under this system, the central bank is to keep a certain
percentage of the total notes issued in gold. The r is to be covered by sound government
securities, trade bills etc. This system remained prevalent in USA, Great Britain and over a large
part of the world. The proportional reserve system was also adopted by State Bank of Pakistan
(SBP) and it remained enforced till December 1965. This system was abandoned in 1965 as it
was rigid and lacked elasticity. The State Bank of Pakistan could not give guarantee for full
convertibility of notes. The State Bank of Pakistan has now adopted a new system of note issue
named as Minimum Reserve System.

(3) Minimum Reserve System. The proportional reserve system of note issue has been
replaced by minimum reserve system in Pakistan in 1965. According to this system, the central
bank is required to keep only a minimum amount of reserve in the form of gold and foreign
exchange securities. The central bank can expand note issue in accordance with the volume of
business activities without backing of gold. The level of currency backing by gold is fixed at Rs.
1200 million in Pakistan. The merit of this system is that it ensures an adequate supply of
currency to meet the business demands of the country. In other words, the method of note issue
is sufficiently elastic. The demerit is that paper currency issued is practically inconvertible in this
system.

METHODS OF NOTE ISSUE :-

Fixed Fiduciary System :-

Under this system the central bank of the country is permitted to issue bank notes of a given amount
without giving gold and silver cover. The fixed quantity of notes allowed by law to be issued is to be
backed by Govt. securities only. This is named the fiduciary limit. The amounts of notes circulated in
excess of the fiduciary limit must be 100% backed by gold.

ADVANTAGES :-
1. Elastic System :-
The first advantage of this system is that it makes the supply of money elastic.

2. Safety :-
It also gives maximum safety because notes can not be issued in excess of the fiduciary limit unless
they are 100% covered by gold.

3. Check On Inflation :-
The inflation can be effectively checked.

DISADVANTAGES :-
1. High Fiduciary Limit :-
If fiduciary limit is high or it has been increased with the passage of time then people will loose
confidence in the currency.

COUNTRIES :-
1. Great Britain is considered the home of this system of note issue and it has successfully survived
since 1844.

2. Japan and Norway are also practicing this system of note issue even today.

PROPORTIONAL RESERVE SYSTEM or PERCENTAGE SYSTEM :-

According to this system the central bank is required by law to keep a fixed percentage varying from
25 to 40 percent against the note issue. The essential feature of this system is the provision of
proportional metallic reserves against the notes in circulation. The reserve ratio may be allowed to
drop below the legal minimum.

COUNTRIES :-
1. It was adopted by France and reserve ratio was 30%.

2. Germany adopted it keeping 40% of gold against the note issue.

3. The federal reserve Bank of U.S.A has also adopted it with slight modification.

ADVANTAGE AND DISADVANTAGE :-

1. Elastic System :-
The main advantage of this system is that it makes the supply of money elastic.

2. Lock Up Of Gold :-
The defect with this system is that it locks up the gold reserves unnecessarily. So we cannot use it for
other purpose.

3. Exchange Management or Modified Proportional Reserve System :-

J.M. Keynes has suggested modified form of proportional reserve system and calls it exchange
management. According to this system the central bank is required by law to keep the percentage
required against the note issue in the form of gold, foreign bills or cash at some foreign banks where
gold standard prevails.

COUNTRIES FOLLOWED :-
This method is followed in India, Pakistan and in many European Countries. The state bank of
Pakistan has to keep 30% of gold silver or approved foreign exchange against the note issue. This
method of note issue economies the use of gold and also makes the currency system elastic.

There are two principles of note issue. The first is the currency principle and the second is banking
principle. There are different views about these principles. One school of thought says that there
should be full convertibility of notes into gold bullion. The second gives importance to the elasticity
of supply.

1. Currency Principle:

According to the advocates of the currency principles, the paper money is an economical and
convenient substitute of metal money. They insist that paper money in circulation should be backed
by 100% gold reserves. There will always be availability of gold for the redemption of notes when
presented which creates stability in price level and exchange rates, because every note issued is
covered by gold behind it.

2. Merits

2.1. Safety and Security:

It gives full safety and security to the paper currency.

2.2. No Danger Of Inflation:

There is no danger of over-issue of the currency, which is an effective check to the possibilities of
inflation.

2.3. Public Confidence:

The currency principle provides greater confidence to the public, because it provides assurance in
ease of convertibility of notes.

3. Demerits

3.1. Inelastic:

It makes the supply of money highly inelastic, because the issuance of notes is only possible on the
availability of gold. So, the government cannot issue notes in case of emergency.

3.2. Dependent:

According to this principle, paper currency can only be primed and issued if there is 1009b gold
cover available against it. The issuance of currency thus completely depends upon the availability of
gold rather than the trade and industry need.
3.3. Lock up of Gold:

There is unnecessary lock up of gold for the currency, which may be used for some other purposes.

3.4. Real World:

It is not acceptable in the real world and has no support from all over the world.

4. Banking Principle:

According to this principle, there is no need to have the reserve of gold and silver for the issuance of
notes. The banks are authorized to regulate the note issue keeping in view the needs of trade and
industry The banks themselves maintain adequate reserves of gold for meeting the obligations of
notes. If there is an over issue of notes, the excess money will be automatically presented for cash
payment and thus the proper ratio will be maintained between the supply of money and the gold
reserves.

4.1. Merits

4.2. Elastic System:

The banking principle is elastic because gold is not kept for current percent value of notes issued.

4.3. Government needs:

This system is fit for meeting the government needs in case of emergencies.

4.4. Popularity:

This system is popular all over the world. Every country is issuing money under this system.

4.5. Surety:

It also provides surety for the convertibility of notes.

4.6. Demerits

4.7. Over-Issue:

In order to meet the demand for money, there may be a further issue of notes beyond to a certain
limit which leads to inflation.

4.8. Economic Crisis:

During economic crisis the convertibility of notes may be refused.

4.9. Balance of Payment:

This is not good for keeping the stable exchange rates. Whenever there is a change in
foreign, exchange rates, the balance of payment position becomes more unfavorable.