KLE Society Degree College Asst Prof R.

Madhankumar
PG Department Asst Prof. S. Darshan

Model - 2
Monetary Standards
Syllabus:
Meaning & Definition, History, Gresham’s Law, Types of Monetary Standards: Monometalism, Bimetallism, Paper currency
and virtual Currency: Features types, Reforms, Pros & Cons. Gold Standard; Meaning, types, features, functions, Pros & Cons,
Domestic and International Gold standards, Working of gold standard: Conditions, Qualities of goods monetary system.
Introduction to paper currency standard: Meaning & Definition, principles of Note issue, right of Note issue, method of Note
issue, Essential of sound currency system. Introduction to SDR or Paper Gold: Meaning & Definition, features, Role of SDR,
Working of SDR, Basket of Currencies, IMF Quota – SDR, SDR Allocations and Interest Rate.

Introduction:
By Monetary Standard simply we mean the type of standard money used in a country. Raymond P
Kent in his book Money and Banking defines Monetary Standards as “Monetary system built upon a
specific standard of Value”. For instance, if the standard Money used is gold, It is called gold standard;
if silver is used as standard Money, it is called silver standard; and if paper currency is used as standard
money, it is called as paper currency standard.

A Monetary standard can be defined as the standard with reference to which the value of monetary
unit is regulated. The standard Money, of course, is that legal money in which the government of the
country itself discharges its own obligations. A Monetary Standard refers to the set of monetary
arrangements and institutions governing the supply of money. The domestic aspect refers to the
institutional arrangements and policy actions of monetary authorities. International aspect relates to
monetary arrangements between nations.

Types of Monetary Standards

Monetary Standard is broadly of three forms:

Types of Monetary
Standards

Paper Currency
Metallic Standard Gold Standard
Standard

I. Metallic Standard: Metallic Coins used as standard monetary units under metallic
standard. Metallic Standard can be classified into Monometallism and Bimetallism

1. Monometallism: It is a monetary system in which only one metal – either gold or silver
– is used as money. When the standard coins are made up of only one metal, say either
gold or silver, the system is called Monometallism. If the standard metal is gold it is
known as gold standard.
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan
Features of Monometallism:
• Standard coins are defined in terms of only one Metal.
• These coins are accepted as unlimited legal tender in the discharge of day to
day obligation.
• There Nominal values as legal tender are fixed.

Types of Monometallism
• Gold Standard
• Silver standard (1835 – 1893)

Merits of Monometallism
1. Simplicity: It is the simplest form of monetary standard. Since only one metal is used as
measure of value, it is easier for common people to understand it.

2. Public Confidence: Under Monometallism coin is made of either gold or silver, it

inspires public confidence.

3. Advantage to foreign trade: It facilitates the country’s foreign trade. By it the foreign
payments become easier and simpler.

4. Non – Operation of Gresham’s Law: Under this monetary standard are made of one
metal, so there is little possibility of operation of Gresham’s Law.

5. It is easily understandable

6. It is easily adoptable to Common people.

Demerits of Monometallism
1. Lack of Price Stability: Under Monometallism, the internal price level lacks stability
because the price of no metal is perfectly stable. With the frequent changes in the price
of the metal, the value of money cannot remain stable.

2. Costly Standard: It is costly standard and all countries particularly the poor countries
cannot afford to adopt it.

3. Lack of Elasticity: The Monometallism standard does not possess the quality of
elasticity. The Monetary Authority under this system cannot expand money supply in
accordance with requirement of the economy.

4. Obstacle in Economic growth: Due to inflexible nature it hinders economic growth of

the country. If however does not make possible for the monetary authority to expand
money supply without having adequate stock and gold or silver.
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan
2. Bimetallism: Bimetallism is a monetary system in which two metals – generally gold
and silver – are used as standard money in a country. When both gold and silver freely
circulate as legal tender at a fixed ratio (Gold Coin 1 = 15 Silver Coin) with each other
and freely minted the system is known as bimetallism.

Features of Bimetallism are:

1. Under this system standard coins are made of gold and silver.
2. Exchange rate between both the coins is fixed by the government.
3. Both the coins are unlimited legal tender.
4. There is no restriction on import and export of these metals.
5. There will be no restrictions on the melting of coins.

Merits of Bimetallism
• Adequate supply of Money: Due to availability of two metals (Gold and Silver)
adequate supply of money is assured to the public in this system.

• Stability in price level: Bimetallism is an ideal system; therefore, stability of internal

prices can be ensured. When bimetallism is adopted on an international scale, then the
shortage of one metal can be offset by increasing the output of the other metal.

• Lower rate of Interest: As we know, under bimetallism two separate metals (gold and
silver) are used for money, hence total supply of money exceeds to its demand and as
a result the interest rates decline.

• Good effect on foreign trade: As we know, under this system two standard coins are
made both gold and silver. Therefore, a bimetallic country can establish trade
relationship with both type of countries where gold standards and silver standards are
being adopted.

Demerits of Bimetallism:
• Operation of Gresham’s Law: In fact, bimetallism is a temporary monetary standard
because it can be permanent only when it is adopted by several countries at a time. If
it is adopted by a single country, it will soon come to an end due to the operation of
Gresham’s Law.

• Increase in speculative activities: Due to Bimetallism speculative activities increase to

a great extent.
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan
1. Paper Currency Standard: Under paper currency standard, there are no standard
Coins. Paper Currency is the main currency of the country. Therefore, it is an unlimited
legal tender. For Making smaller payments, Coins made of cheaper and lighter metals
are used by the public. Paper Currency are not convertible into any metal. It is also
sometimes referred to as Fiat Standard, Because paper notes under this standard are
inconvertible and are still regarded as full legal tender money. In fact there is no
difference between inconvertible paper money and fiat money.
Under this system, the controller of currency regulates the value of money by
controlling its supply. Like the gold standard, this system does not work
automatically.

Merits of Paper Currency Standard:

• Stability in internal price level: Under this system, the central Bank (Monetary
Authority) can establish stability in the internal price level by regulating the
supply of money according to the trade requirements of the country.

• Helpful in emergency: This system enable a country to meet national

emergencies like war and other natural calamities in a more effective manner
than the other metallic standard.

• Speedily Economic Development: It is the most suitable standard for a

backward country because it enable it to develop itself speedily through deficit
financing instead of looking for financial resources through taxation and public
borrowings.

• Easy To manage: Under this standard currency is not lined with any metal.
The Monetary authority is free to Manage the money supply according to the
trade requirements of the country.

• Fully Employment of resources: Under this Monetary system the economic

resources of the country are fully employed consequently the burning problem
of unemployment disappears.

Demerits of Paper Currency Standers:

• Fear of Inflation: This standard suffers from the fear of inflation because the
currency of the country is not linked with metal hence, the monetary authority
can increase the supply of money without keeping additional metallic reserve.
• Instability in internal prices
• Absence of Automatic working
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan
Qualities of a Good Monetary Standard
A Good monetary system possesses the following qualities:

• Stability in the value of Money: The monetary standard should be such as to ensure
stability in the internal price-level.

• Convertibility: The Monetary system need to possess the quality of convertibility on

two ground. i) it inspires public confidence in the monetary system ii) it facilitates
international payments.

• Simplicity: To inspire public confidence, it is essential that the monetary system of the
country should be simple and easily understandable.

• Economy: The monetary standard should be such as to enable an economical use of

gold and silver because an expansive monetary system becomes a burden on the
country.

• Elasticity: The Monetary system should be of such type which can change the money
supply according to the trade requirements of the country.

• Legality: A good monetary standards should be based on law enacted by the law.

• Automatic Working: A good monetary standard must possess the quality of

automatic working, which the paper currency lacks.

Introduction to Gresham’s Law

Gresham’s Law was propounded by Sir Thomas Gresham, the financial adviser to Queen
Elizabeth and was a London merchant. During the reign of Queen Elizabeth, an effort was
made to reform the system of Coinage. The Tudor Kings before her had put forth large
number of debased coins into circulation. Elizabeth tired to oust these from circulation by
issuing new coins. But these went out of circulation as fast as they were issued. Perplexed, the
queen sought the advice of Sir Thomas Gresham who gave an explanation of this
phenomenon, sir Thomas Gresham stated in substantially the following terms.

Whenever legal tender coins of the same face value, but of different weights or degrees of
fineness, are in concurrent circulation the light weight or base coin tend to drive the full
weight pure coins out of Circulation.

According to Gresham’s Law “Bad Money drives good Money out of Circulation”
When two kinds of Money, bad and good circulate together, other things the same, the bad
money will remain in circulation and the good money will go out of circulation. BY Good
money here we mean new full valued coins of standard weight and fineness and bad money is
that which has been debased or is worn out so that it is of less value.
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan
It was introduced by Sir Thomas Gresham. He was a big businessman and also economic
advisor of queen Elizabeth. According to Sir Thomas Gresham “Bad Money derives out good
money out of circulation”.

1. Good Money: Good Money means that money which is of full value and any
depreciation in it does not affect its economic value. In context of paper money, good
money is that which is not torn or worn.

2. Bad Money: Bad Money means the money which losses its original value due to
deprecation or any cause. According to bimetallism money whose value is less than
its internal value.

Definition Gresham’s Law

“When bad money and good money both are circulating side by side as a medium of exchange
bad money derives goods money out of the circulation other thing remaining the same”.

Meaning of Gresham’s Law

It refers to when good and bad money are circulating together as legal tender, bad money
tends to drive good money out of circulation.

Causes of Operation of Gresham’s Law

• Individuals’ preference to hoard over valued currency with him as store of Value.
• Melting of Metallic money for various ornamental articles purpose.
• Stability in the value of the standard metal also encourages the individual to hoard it.
• Human’s Psychology of keeping new coins, currency and throwing old coins and
currency in operation

Assumptions of Gresham’s Law

1. The different Currencies in circulation are full legal tender.
2. The Total Supply of Money exceeds the total demand for Money.
3. The Supply of overvalued currency is sufficient to meet the currency demand of the
people.

Condition under which Gresham’s Law Operates

This law is applicable in the following three cases: -

1. Under Monometallism: If Coins of the same metal (Say Gold), but of Varying weight
or fineness or both, circulate at the same face value, the old and worn out coins will
tend to drive the newly minted full- weight pure coins out of circulation. The good
coins disappear because some of them are kept back hoarded, while others are melted
down, exported or fraudulently depreciated in weight.

Suppose that a country is on Gold Standard. A Gold coin should have certain weight
and fineness(purity) by Currency Law. Coins whose weight is less than the Standard
weight are called worse coins (bad money). Coins whose weight is equal to the
standard weight are called better coins (Good Money). IF the both coins circulate
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan
together as legal tender at the same face value, the worse coins will drive out the better
coins from circulation. In other words, bad money tends to drive out good money from
circulation.

2. Under Bimetallism: Under a Bimetallism standard when gold and silver coins are
freely minted (Issued) and are ultimately legal tender, the overvalued at the minted to
drive the undervalued metal out of circulation. Thus, when the market ratio of gold
and silver differs from the mint-ratio, one or the other metal is driven out of
circulation. For Example, in a country two kinds of coins are current , Gold and Silver
coins at the mint rate of 1 gold coin equal to 15 Silver coins. Suppose the market value
of gold and silver changes in such a manner that the market value of these coins
becomes one gold equal to 16 silver coins. In this case the gold coins will disappear
from circulation and will be hoarded or melted or exported. If on the other hand, the
market value becomes one gold coin equal to in silver coins then silver will be driven
out of circulation and gold will be retained in circulation.

3. Under Paper Money: When metallic money and paper money circulate together as
standard money, paper money (Bad money) tends to drive metallic money out of
circulation. Metallic coins are either exported or Hoarded or melted down.

How This law operates

It extended to all standards as follows:

1. Under Mono-metallism:
• Old Coins of gold = bad money
• New coins of gold = Good money

According to Gresham’s Law the old and worn-out coins drive new and full weight coins out of
standard.

2. Under Bimetallism:
• Gold Coins (overvalued money) = Bad Money
• Silver Coins (Undervalued Money) = Good Money
According to Gresham’s Law, the overvalued coins will drive undervalued coins out of circulation.

3. Under paper Standard:

• Superior Metal coins are = Good Money
• Paper Notes = Bad Money
According to Gresham’s Law, an inferior currency if now limited in amount will drive out the superior
currency.
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan
Merits of Gresham’s Law
1. Usefulness of good Money
2. Fixed parity Ratio
3. Sufficient Money Supply
4. Sufficient Supply of bad money
5. Content of Pure Metal
6. Acceptability of bad money
7. Distinction between good money and bad money
8. Development of banking habit
9. Convertibility

Limitation of Gresham’s Law:

1. If the supply of currencies of both kinds (Inferior and Superior) is in excess of the
demand, inferior currency will not drive superior currency out of circulation.
2. If the intrinsic value of the superior currency is not less than its face value then this
law will not operate.
3. If one of the currencies is not limited in its legal tender the law does not operate.
4. When the bad money is in the form of token coins and is limited in supplies.
5. When different moneys are meant for different purpose.

Important Question:

1. What do you understand by Gresham’s Law? (BU Bangalore University 2019,2011)

2. State the essence of Gresham’s Law. (BU Bangalore University 2019)

GOLD STANDARD
Gold standard is a system of currency wherein the value of the monetary unit of a country is
regulated with reference to gold. Gold standard is a copy of Mono-Metallism in which gold is
used as standard metal under the system of Gold standard either the coinage is in gold or the
money is convertible into gold on demand. The value of currency is determined in gold
standard because gold is the most standard metal. Gold standard is quite old. It was
discovered by mercantilists who were in favor of gold because it was only metal having the
quality of having universally durable price.

In 1817, gold standard was adopted in the United Kingdom (England). The UK was the
pioneering country which adopted gold standard. In 1873, gold standard was adopted in the
Germany; in 1878, it was adopted in France; and in 1900, it was adopted in the united states
of America (USA). In the early 20th Century, this standard was adopted in Russia, Holland,
Austria, etc.
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan
Meaning of Gold Standard
Gold standard is referred to as a monetary system in which gold is used as standard money. It means
that the monetary unit of the country will be declared equal to certain weight of gold of certain fineness.

Definition of Gold Standard

According to Benham “A country is on the gold standard when the purchasing power of the unit of its
currency is kept equal to the purchasing power of a given weight of gold”.

Characteristics of Gold Standard

1. Free Coinage: Under gold standard free coinage prevail in most of the economies.
2. Determination of value in gold: Money in circulation is either made of gold or its value
is determined in gold.
3. Quality of Gold under gold standard, specific quality of gold is also fixed up.
4. Free Trade of Gold: No restriction is imposed on the import and export of gold but free
bargaining in allowed.
5. Unlimited legal tender: Under gold standard coinage in circulation are of unlimited
legal tender quality.
6. Role of the Government: The Government is issuing authority i.e, Central Bank (For
instance RBI in India) is bound to sell and purchase the gold in the free market at pre-
determined fixed rate.

Types of Gold Standard

Gold Currency or Circulation standard

Gold Bullion Standard

Types of Gold Standard

Gold Exchange Standard

Gold Reserve Standard

Gold Parity Standard

KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan

1. Gold Currency Standard:

Gold Currency standard is the oldest type of gold standard. Under this standard, gold coins
are circulated along with other forms of currency in the country. In other words of Crowther
“a Currency system in which gold coins either form the whole circulation or else circulate
equally with notes is known as the full gold standard”. This standard was in practice in the
leading countries like the USA, Germany and France before 1914. Gold standard implied gold
currency standard under this standard gold acts both as a medium of exchange and as measure
of value.

Main features of Gold Currency standard

• Gold coins of definite weight and fineness will be in circulation

• Gold coins will be full-bodied, i.e, the face value of the gold coin will be equal to its
intrinsic value.
• There will be free coinage in the country
• There will be no restrictions on the melting of gold coins
• There will be no restrictions on the export and import of gold coins.

Merits of Gold Currency Standard

1. Price Stability: Gold currency standard stabilizes the price level in the country.
2. Automation: It was automation to the economic development and money expansion:
since it depends upon the amount of gold available.
3. Public Trust: It Possesses relatively more public trust.
4. Easy: Currency standard possesses the merit of easy to follow and determine the value
of gold

Demerits of Gold Currency Standard

1. Rigidity: Sometime problem of rigidity in the money supply arises under gold currency
standard because of the scarcity of gold.
2. Lacking International co-operation: It becomes difficult under this system in promoting
international co-operation on monetary lines
3. Economic development: To achieve economic development for a poor economy becomes,
difficult due to shortage of gold.

2. Gold Bullion Standard

Gold bullion standard is another type of gold standard in which gold coins do not circulate in
the country. Under this standard, the currency notes are convertible into gold bullion at a
fixed rate. This standard is adopted to economic on gold but without the circulation of Gold
coins.

Gold bullion standard is a modified form of gold standard. It was adopted by some countries
of Europe after the first world war. It was adopted by Great Britain in 1925. This system was
finally given up by France in 1936. Under this system whole gold is the measure of value, it
no longer circulates as coins. The government herein, does not issue gold coins, but binds
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan
itself to purchase and sell gold bullion in exchange for internal currency which may consist of
paper money and coins of baser metals at fixed rates.

Features of Gold Bullion Standard

• Circulation: Under this system currency was to circulate in any metal other than gold.
• Legal Tender: It is full legal tender money convertible into gold.
• Free Trading: There is no restriction on imports and exports of gold.
• Role of Central Bank: Under this system, central bank was to purchase gold from the
public at a fixed price.

Merits of Gold Bullion Standard

• Stable
• Elastic
• Adjustment

Demerits of Gold Bullion Standard

• Government’s Interference
• Lack of Public Trust

3. Gold Exchange Standard

Gold Exchange standard in another type of gold standard. Under this standard gold coins will
not circulate in the country as under gold currency standard. Gold exchange standard was
adopted by countries like India, Russia etc.,

Under this system, the government takes no responsibility of converting internal currency
into gold for meeting domestic requirements. On the contrary, the government undertakes to
convert local currency into the currency of another country based on the gold standard for
making foreign payment. This system was found suitable for underdeveloped countries
which would not afford the luxury of a full gold standard.

Features of Gold Exchange Standard

• It Yields Income.
• IT reduces pressure of Gold
• It secures stable price.
• It is highly Economical
• It secures stable exchange rate

Merits of Gold Exchange Standard

• Price Level
• Rate of National Currency
• International trade
• Market Stability

Demerits of Gold Exchange Standard

KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan
• Automatic
• Motivation
• Dependence

Gold Reserve Standard

Gold reserve standard was developed in 1936 mainly to stabilize exchange rate. The main
objectives of this standard were to ensure stability in exchange rates. This system could not
continue for long. With the outbreak of the second world war, the system came to an end.

Gold Parity Standard

Gold parity standard is the modern version of the gold standard. Under the gold parity
standard, every member country of the International Monetary Fund (IMF) has to define the
par value of its currency in terms of gold in order to determine the exchange.

Advantages of Gold Standard

• Promotes Confidence in the Monetary System: The gold standard promotes

confidence in the monetary system because gold being universally desirable has value
in itself aside from its monetary use.

• Simplicity: Gold standard is considered to be a very simple monetary standard. It

avoids the complication of other standards and can e easily have understood by the
general public.

• Automatic Monetary System: All that is essential is to make an internal monetary

system automatic under a gold standard to fix certain requirements as to gold reserves
in the monetary law and then to observe the rules of the game so determined.

• Price Stability: Perhaps the most cogent argument which can be presented in favor of
a specific monetary standard, from the domestic as apart from the international point
of view, is that it makes possible a seasonable degree of stability in the price of view.

• Exchange Stability: Another important merit is that gold standard secures the stability
of foreign exchange rate.

• Expansion of International Trade: These were made possible to stable exchange rate
and stable value of gold in countries. Theses lead to the expansion of international
trade and capital movement.
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan
Disadvantages of the Gold Standard

• Lack of Elasticity: Under the gold standard the monetary system lacks elasticity,
under this standard, Money supply depends upon the government reserves and the
gold reserve cannot be easily increased.

• Fair Weather standard: The gold standard has been regarded as a fair-weather
standard because its works properly in normal or peaceful time, but during the period
of war or economic crisis, it invariable fails during abnormal periods.

• Economic Dependence: Under gold standard the problems of one country are passed
on to the other countries and it is difficult for an individual country to follow
independent economic policy.

• Rigid Standard: Because it was bad on gold every country had to circulate gold coins
or keep gold reserve.

Conditions for gold standard

Gold standard will work smoothly and successfully only when the following six conditions
are satisfied:
• The rules of the gold standard game should be strictly observed.
• The main aim of the monetary policy of any gold standard country should be to
maintain stable exchange rates.
• There should be no restrictions on the movement of goods between gold standard
countries.
• The economic system of the gold standard countries should be flexible and elastic.
• There should be no movement of short-term funds between countries on account of
panic and fear.
• There should be political and financial stability in the gold standard countries.
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan

Introduction to Paper Currency Standard

The Paper Currency is the accepted currency system managed by the government. The system
is also known as Managed currency Standard. Managed money is also known as paper
standard. The regulation and control of paper money standard lies in the hand of government.

The Paper Currency standard came into being due to the failure of the gold standard and
other metallic standards. In Modern time the paper currency standard performs the functions
of Money. Under this system, paper currency circulates in the market, at the same time coins
are also circulates to make the fractional payments. Currency issued by the Central bank of
the country, but its control lies in the hand of government.

Meaning of Paper Currency Standard

Paper Currency Standard means a system in which the paper money acts as the standard
money. Under this standard, money consists of currency and Coins which are not convertible
into gold or silver.

Features of Paper Currency Standards

• It is accepted as unlimited legal tender.
• It is circulated as standard Money.
• It is national in character.
• The unit of money is not defined in terms of commodity.
• The international exchange value of paper currency depends upon its purchasing
power.

Merits of Paper Currency Standard

1. Portability: Paper money is easy to carry in comparison to the metallic money. Paper
currency in huge amount can be taken away from one place to another place without any
difficulty. It can be kept without any difficulty and there is also easiness in the
transactions.

2. Economical: To issue paper money is not a costly affair for the issuing government. It
involves less expenditure. It also leaves the government to the use the precious metals in
more important matters.

3. Flexible and Elastic: The issue of paper currency is quite flexible for the economy.
Government can issue new currency notes without any difficulty. More currency can be
printed in less time. It can be adjusted according to the demand of currency in the market.
It is elastic currency system which keeps the capacity to adjust itself with the requirements
of the economy.

4. Helpful during emergency: In the time of financial emergency government can issue notes
to meet the economic difficulty. During war huge amount of money is required which can
be easily met by this system of issuing currency.
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan
5. No Problem of Scarcity: There is no scarcity problem the government regarding the
shortage of material. Such situation may come in the case of metallic currency system due
to the scarcity of gold or the standard metal but in the case of managed money it is never
expected.

6. Helpful in the formation of policies: Through the paper currency government are
absolutely away from any restraint. They can adopt any suitable policy to stabiles prices
and business to bring the conditions fit for full employment.

7. No Loss due to Debasing: In case of precious metals circulating as currency great loss is
incurred due to wear and tear of the coins. But in the case of paper currency no such fear
originates.

Demerits of Paper Currency Standard

1. Inflation: It is not difficult for the government to issue paper currency. There is no
restriction, like that of scarcity of metals. Finding it easy, government may issue such an
amount of currency which may be more than market demand. It may adversely affect the
economy.

2. Non-monetization: Paper money does not posses any standard value. It is accepted in the
market because, it keeps legality behind it, in the case of inflationary situation,
government can create a very difficult situation before the people by non-monetization or
demonetizing paper currency.

3. Limited area of function: Paper money is national in its operation. It operates only in the
national territory without any international recognition. In case of gold standard, the
situation is not so. But in case of paper standard every government issues its own currency
which operates in its own territory.

4. Instability in exchange rate: Under paper standard every country issues paper currency
according to the requirements of its own country.

5. Increasing Demoralization: Paper Money also includes demoralizing atmosphere in the

economy. Its fluctuations affect the price level and further unstable price level affect the
moral standard of the thinker.

Types of Paper Money:

1. Representative Paper Money
2. Convertible Paper Money
3. Inconvertible Paper Money
4. Fiat Paper Money
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan
Principles of Note Issue
There are two main principle of Note Issues:

1. The Currency Principle: Under this principal security is the first consideration and
hence the note-issuing authority is required statutorily to keep Cent – Percent Metallic
Cover. On order to ensure public confidence in currency and stability in price level
this principle exercises some check on the note issuing authority. This principle of note
issue was first adopted by sir Robert Peel In England in the year 1844.
Under this principle, hundred per cent safety and security for the currency notes in
circulation is ensured. Paper Currency notes are merely used as an instrument that
helps eliminate the waste in circulation of the precious metals.

Merits of Currency Principle are:

• In order to hold cent percent metallic cover, the issuing authority is not free for
any kind of arbitration.
• Public have full confidence in the system
• Saving in depreciation of Metal.

Demerits of Currency Principle are:

• Lack of Flexibility
• Lack of Economy
• Not Suitable for Poor Countries

2. The Banking Principle: Under this banking Principle of note issue, there is no need to
provide for hundred percent metallic reserves for currency notes in circulation. But a
Minimum percentage of gold or silver reserves against every currency note issue is
provided, the rest being covered by certain specific assets such as Government
Securities, Trade bills, etc., The banking principle of note issue provides elasticity and
ignores security. The authority is free to expand the quantity of paper currency looking
to the need of trade and industry in the country.

Merits of Banking Principle:

• It ensures elasticity in the issue of currency notes
• It Considers the demand of trade and industry
• It is in practice in most parts of the world
• It is economical and autonomous.

Demerits of Banking Principle are:

• Lack of Security
• There is always fear of Inflation
• Lack of people’s Confidence.
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan

Various System of Issuing Managed Money (Methods of Note Issue)

In the light of the above two principle, following are the eight system of issuing paper
Currency.

1. Minimum Reserve System: In this system a minimum gold reserve is kept by

the central bank according to the provisions of the law. There is no upper limit
to the issue of currency.
This system is considered to be one of the easiest, economical, and elastic
method of issuing currency. This System has been adopted in India which
requires the Reserve Bank of India to keep Minimum Reserve of 200 Crores (Rs.
115 Crores in the form gold and Rs. 85 Crores in the form of Foreign Exchange)
According to an amendment (1957) the RBI has been empowered not to keep
foreign exchange provided bank is able to get approval of the central
government for the purpose.

Merits of Minimum Reserve System:

• Economical
• Flexibility
• Wider Suitability

Demerits of Minimum Reserve System:

• Fear of Inflation
• Non-Convertible
• Lack of Public Confidence

2. Proportional Reserve System: In this system the central Bank is required to

keep a proportionate reserve of the currency issued by it. It is not fixed as to
what should be the amount of reserve but it depends upon the amount of paper
currency. The general proportion is kept between 25% and 40% of the total
currency.
This system is less flexible that minimum reserve system. But if due to any
reason the gold Reserve falls it will curtail the total supply of currency.

Merits of Proportional Reserve System:

• Flexible
• Convertibility
• No Fear of inflation
• Public Confidence
• Economical
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan

Demerits of Proportional Reserve System:

• Costly
• Inflexibility
• Impracticable Convertibility

3. Fixed Fiduciary System: Under this system the law of the nation provides for
the issue of unbacked, unsupported money by the government. If the
government wants to issue more currency beyond this limit then it has to back
such currency by 100% gold reserve.
In the system of note issue, the issuing authority (Central Bank) is empowered
to issue only a fixed amount of currency notes against securities and the
currency notes issued over and above this limit should be backed up by
hundred percent metallic reserves, say gold or silver. This system was adopted
first of all by England through to Bank of England Act passed in 1884

Merits of Fixed Fiduciary System:

• Public Confidence
• Safety
• Avoids fear of over-issue

Demerits of Fixed Fiduciary System:

• Difficult to Measure Fiduciary Limit
• Lack of Flexibility
• Expensive
• Impracticable

4. Fixed Maximum Fiduciary System: Under the Maximum Fiduciary System of

Note Issue, A maximum limit for currency notes in circulation is fixed without
any gold reserve by law. The Maximum amount of currency notes that can be
issued by the central bank of a country is fixed by the government. The central
bank cannot issue currency notes beyond this limit. At the same time central
bank is given complete freedom with regard to the forma and amount of
reserves that should be kept. The maximum limit fixed will generally be in
excess of normal requires.

Merits of Fixed Maximum Fiduciary System:

• Saving of Precious Metal
• Flexible
• No Danger of Inflation
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan

Demerits of Fixed Maximum Fiduciary System:

• Misuse of Power
• Limited Flexibility
• Wrong Determination

5. Simple Deposit Scheme: This is the simplest method to issue paper currency
in any economy. The paper money which is issued is called Representative
Paper Money since it represents the gold reserve kept at its back
In the system 100% of the currency is backed by gold reserve hence 100% gold
reserve is required. It is one of the safest ways to issue paper currency but it is
too costly and rigid system. In the absence of gold, currency can be not issued
in spite of the urgent requirements in the economy.

Merits of Simple Deposit Scheme:

• Public Confidence
• Simple
• Convertibility
• Control of Inflation

Demerits of Simple Deposit Scheme:

• Lack of Flexibility
• Costly

6. Percentage of Deposit Scheme: This system provides for keeping an amount

of reserve which determines percentage of the total currency issued. This
system facilities that the reserve can be kept in a fixed percentage in the gold
and foreign exchange.

7. Bond Deposit Scheme: This system provides for issuing of paper money
without keeping gold or any metallic reserve. The Currency is backed by
government bonds and securities.

8. Original Assets system: This is a peculiar system of issuing currency notes.

Under this system Bank can issue the currency with the full backing of its own
assets. No other Reserve than the assts of the bank is required.
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan

Essential of Sound Currency System

1. Simple: The currency system must be simple so that an average man can
understand it. A complicated system cannot inspire public Confidence.
2. Elastic and Automatic: The Currency system must be elastic and automatic so
that it expands or contracts in response to the requirement of Trade and
industry
3. Economical: The System must be economical. A costly medium of exchange is
a national waste. It is unnecessary. That is why all countries use mostly paper
money.
4. Stability: A sound Currency system Must maintain stability of the external
value of the currency. This means that its purchasing power over goods and
services in foreign countries, through its command over definite amount of
foreign currency, should remain constant.
5. Reasonable: It must maintain a reasonable stability of price in the country.

Special Drawing Rights or Paper Gold

The IMF uses an SDR as an artificial currency instrument and depends upon it for
internal accounting purposes. SDR is set up from a basket of popular currencies across
the globe. The IMF assigns SDRs to its member countries, showing full faith and
support by their governments. The SDR is re-evaluated every five years.

The SDR was commissioned with a vision of becoming a highlighting aspect of

international reserves. On the other hand, the gold and reserve currencies would form
a minor marginal element of such reserves.

A member country must get access to official reserves to get involved in the SDR
system. Such official reserve consisted of the reserves of gold and globally accepted
foreign currencies belonging to the central bank or government. These could be used
to buy the local currency in foreign exchange markets to maintain a stable exchange
rate.

However, the international supply of the two principal reserves, such as the U.S.
dollar and gold was not sufficient to support growth in global trade and the ongoing
related financial transactions. This lacking prompted member countries to form an
international reserve asset under the guidance of the IMF. The value of the SDR is
calculated from a weighted basket of major currencies, including the U.S. Dollar,
Chinese Yuan, Japanese Yen, the Euro, and British Pound. Its value is outlined in U.S.
Dollars. The IMF uses the SDR interest rate (SDRi) as the basis for calculating
the interest rate charged on the borrowings made by member countries from it. Also,
compensation shall be paid to the members for their remunerated creditor positions
in the IMF at the same rate
KLE Society Degree College Asst Prof R. Madhankumar
PG Department Asst Prof. S. Darshan

Special Drawing Rights (SDRs) were a part of the monetary system that was created
post World War-2 in the Bretton Woods arrangement. Since the United States had
almost all of the gold reserves of the world at that time, the Special Drawing Rights
(SDRs) were intended as a supra-national currency that could be used instead of gold,
thereby reducing dependence on gold.

However, the idea of an abstract currency replacing gold has not caught up with the
world till date. The Special Drawing Rights (SDRs) were virtually unheard of till the
year 1968 and are still not very popular. The average person who is not connected to
the Forex markets is not even aware of the existence of Special Drawing Rights (SDRs)!

The Special Drawing Rights (SDRs) are basically a combination (weighted average) of
multiple currencies. This means that the International Monetary Fund (IMF) has its
own reserve which has multiple currencies. Based on the value of these reserves, the
IMF creates and distributes Special Drawing Rights (SDRs).

Each unit of Special Drawing Rights (SDRs) consists of 4 major currencies. The Special
Drawing Rights (SDRs) derives 44% of its value from the United States Dollar, 34%
from the Euro, 11% from the Japanese Yen and 11% from the Pound Sterling.

Since the Special Drawing Rights (SDRs) is nothing but a weighted average of multiple
currencies, the interest rate due on the Special Drawing Rights (SDRs) is also nothing
but a weighted average of all the currencies

The SDR is an international reserve asset, created by the IMF in 1969 to supplement
its member countries’ official reserves. So far SDR 204.2 billion (equivalent to about
US$293 billion) have been allocated to members, including SDR 182.6 billion allocated
in 2009 in the wake of the global financial crisis. The value of the SDR is based on a
basket of five currencies—the U.S. dollar, the euro, the Chinese renminbi, the Japanese
yen, and the British pound sterling.

Meaning of Special Drawings Rights

SDR is an international reserve asset created by the IMF to supplement the official
reserves of its member countries.

The SDR is not a currency. It is a potential claim on the freely usable currencies of IMF
members. As such, SDRs can provide a country with liquidity.

A basket of currencies defines the SDR: the US dollar, Euro, Chinese Yuan, Japanese
Yen, and the British Pound.