Monetary System

Introduction
• A Monetary System is defined as a set of policies,
frameworks, and institutions by which the government
creates money in an economy.
• Such institutions include the mint, the central bank,
treasury, and other financial institutions.
• There are three common types of monetary systems –
commodity money, commodity-based money, and fiat
money.
• Currently, fiat money is the most common type of
monetary system in the world. For example, the US
Dollar is fiat money.
 Types of Monetary Systems

1. Commodity Money
• This is made up of precious metals or other
commodities that have intrinsic value.
• In order words, the monetary system uses the
commodity physically in terms of currency.
• This form of money retains its value even if it’s
melted down.
• For example, gold and silver coins have been
commonly used throughout history as a form of
money.
Commodity Money
Commodity Money
 Types of Monetary Systems
2. Commodity-based Money
• This draws its value from a commodity but
doesn’t involve handling the commodity
regularly.
• The notes don’t have tangible value but can be
exchanged for the commodity it is backed by.
• For example, the US Dollar used to draw its
value on gold.
• This was known as the Gold Standard.
Commodity-based Money
Commodity-based Money
 Types of Monetary Systems
3. Fiat Money
• In this system the currency, which by government decree
is legal tender, i.e., that the government guarantees the
value of the currency.
• Today, most monetary systems are fiat money because
people use notes or bank balances to make purchases.
• Fiat money is made up of paper currency or a base metal
coin.
• However, today, most of fiat money is in the form of bank
balances and records of credit or debit card purchases.
Fiat Money
Fiat Money
 Bimetallism

• Bimetallism, is a monetary standard or system

based upon the use of two metals,
traditionally gold and silver, rather than one
(monometallism).
• The typical 19th-century bimetallic system
defined a nation’s monetary unit by law in
terms of fixed quantities of gold and silver
(thus automatically establishing a rate of
exchange between the two metals).
 Bimetallism
• The system also provided a free and unlimited market for
the two metals,
• imposed no restrictions on the use and coinage of either
metal, and
• made all other money in circulation redeemable in either
gold or silver.
• A major problem in the international use of bimetallism
was that, with each nation independently setting its own
rate of exchange between the two metals, the resulting
rates often differed widely from country to country.
 Bimetallism
• In an attempt to establish the bimetallic system on an
international scale, France, Belgium, Italy, and Switzerland
formed the Latin Monetary Union in 1865.
• The union established a mint ratio between the two metals
and provided for use of the same standard units and issuance
of coins.
• The system was undermined by the monetary manipulations
of Italy and Greece (which had been admitted later) and came
to a speedy end with the Franco-German War (1870–71).
• The future of the bimetallic standard apparently had been
sealed at an international monetary conference held in Paris
in 1867, when most of the delegates voted for the
gold standard.
 Bimetallism
• Supporters of bimetallism offer three arguments for it:
(1) the combination of two metals can provide greater monetary reserves;
(2) greater price stability will result from the larger monetary base; and
(3) greater ease in the determination and stabilization of exchange rates among
countries using gold, silver, or bimetallic standards will result.
• Arguments advanced against bimetallism are:
(1) it is practically impossible for a single nation to use such a standard without
having international cooperation;
(2) such a system is wasteful in that the mining, handling, and coinage of two metals
is more costly;
(3) because price stability is dependent on more than the type of monetary base,
bimetallism does not provide greater stability of prices; and
(4) most importantly, bimetallism in effect freezes the ratio of the prices of the two
metals without regard to changes in their demand and supply conditions. Such
changes can disrupt attempts to maintain the double standard. .
 Gresham’s law
• Gresham’s law, observation in economics that “bad money
drives out good.”
• More exactly, if coins containing metal of different value have
the same value as legal tender, the coins composed of the
cheaper metal will be used for payment, while those made of
more expensive metal will be hoarded or exported and thus
tend to disappear from circulation.
• Sir Thomas Gresham, financial agent of Queen Elizabeth I,
was not the first to recognize this monetary principle, but his
elucidation of it in 1558 prompted the economist H.D.
Macleod to suggest the term Gresham’s law in the 19th
century.
 Gresham’s law
• For example, during the period from 1792 to 1834
the United States maintained an exchange ratio
between silver and gold of 15:1, while ratios in
Europe ranged from 15.5:1 to 16.06:1.
• This made it profitable for owners of gold to sell
their gold in the European market and take their
silver to the United States mint.
• The effect was that gold was withdrawn from
domestic American circulation; the “inferior”
money had driven it out
Bimetallism
Bimetallism
Bimetallism
Bimetallism
Bimetallism
 Monometallism

• the monetary standard being based on one

metal, silver or gold and not on both as is the
case in bimetallism.
• Silver Standard
• Gold Standard
• Paper Gold Standard or the SDR Standard
 Silver Standard:

• Under a silver standard, the value of the monetary

unit is fixed and maintained in terms of silver.
• This is usually done by the free coinage of silver
into coins of a given weight and fineness.
• India, for instance, was on silver standard from
1835 to 1893: The rupee was freely coined and its
weight was fixed at 180 grams, 11/12 fine. At
present, no country in the world is on the silver
standard.
 Gold Standard:
There are several distinct phases through which
gold standard passed.
(i) Gold currency standard,
(ii) Gold exchange standard,
(iii) Gold bullion standard, and
(iv) The latest to appear, gold parity standard.
 Gold currency standard
• This is also called Full Gold Standard:
• A country is on a full gold standard when gold serves not only as
standard of value but also circulates as coins.
• It is subject to free coinage, so that its face value is equal to its
intrinsic value.
• Before 1914, Great Britain had this type of gold standard and so
had the U.S.A., France, Germany and other European countries.
• Gold provides for the currency a solid and frangible security.
• It also helps those who have to travel abroad, for they can carry
their own currency and be sure of its acceptance anywhere in the
world.
• It is called the traditional or the orthodox gold standard.
 Gold currency standard
• We may illustrate its working from the example of pre-1914 Britain. Gold circulated
in the form of sovereigns of a given weight (113.1/623 grains) of pure gold, plus a
little alloy.
• The actual weight of the sovereign was 123.27447 grains 11/12 fine. In other words,
one ounce of gold 11/12 fine could be coined into £ 3 17s 10 ½ d in English money.
Actually, the Bank of England only gave £ 3 17s. 9d for every ounce of such gold.
• To purchase an ounce of standard gold from the Bank, one had to pay £ 3 17s, 10d.
per ounce.
• Under this system, therefore, the purchasing power of a British Sovereign could not
rise appreciably above or fall appreciably below 123.27447 grains of gold 11/12 fine
or 113.1/623 grains of pure gold.
• This system could not be maintained during the World War 1914-18, and had to be
given up.
• In April 1925, Great Britain restored the Gold Standard, but of a different variety,
viz., the Gold Bullion Standard.
 Gold exchange standard
• It is a gold standard for making foreign payments only; inside
the country, the people use token coins and paper notes.
• For making foreign payments, the external value of the home
currency is fixed in terms of a foreign currency that is
convertible into gold.
• The currency authority of the home country is ever prepared
to make available the foreign currency (which is convertible
into gold) in exchange for home currency.
• Also, when the home country’s nationals receive payments
from abroad in terms of currencies convertible into gold, the
currency authority of the home country converts it into home
currency.
Gold exchange standard
 Gold exchange standard
• Two reserves are kept to ensure the smooth working of this
system: One reserve is kept in the form of the home currency
inside the country and another reserve is kept at a foreign center
in gold.
• When the home country has to receive payments from abroad,
then gold or foreign currency convertible into gold is paid into the
reserve kept at the foreign centre and, in exchange, the internal
currency is issued from the home reserve.
• When payments have to be made abroad, then the internal
currency is paid to the currency authority within the home country
and is put into the home reserve.
• The currency authority gives in exchange gold out of the reserve
kept at the foreign centre.
 Gold exchange standard
• The gold exchange standard was in operation
in India from 1907 for about 1907 years, when
during the First World War it broke down.
After the war (in 1920), it was again tried [at a
higher exchange rate of 2sh. (gold) instead of
the pre-war 1sh. 4d.] but had to be given up.
Under this system, the exchange value of the
rupee was fixed in terms of British pound
sterling which was on gold standard.
 Gold bullion standard,
• Under this system, the value of the currency is fixed in terms of
gold by making such currency convertible into gold (bullion,
not coin) and vice versa.
• But gold does not circulate as coins. In the United Kingdom,
under the Gold Bullion Standard, the- Bank of England was
willing to buy any amount of gold at £3 17s. 9d per ounce
11/12 fine and to sell it in minimum amounts of 400 ounces at
£3 17s. 10d.
• This was the same rate as before 1914. Gold was allowed freely
to move into or outside the country.
• No gold coins circulated.
• The idea was to make, gold available only for foreign payments.
Gold bullion standard
 Gold bullion standard,
• The Gold Bullion Standard was adopted in
India in 1927 on the recommendation of the
Hilton Young Commission.
• The currency authority was placed under an
obligation to buy or sell gold at rate^
announced before harm subject to a minimum
of 400 ounces of gold.
 Gold parity standard.
• The latest to enter the list of gold standards is the gold parity
standard.
• This is the type which is supposed to prevail under the aegis of
the International Monetary Fund.
• Under this system, no gold coins are put in circulation.
• Gold does not serve as a medium of exchange.
• The internal currency consists largely of notes and some form of
metallic money but certainly not of gold;
• nor is these notes convertible neither into coins as under the full
gold standard, nor into gold bullion as under the bullion standard,
nor into particular foreign currency based on gold as under the
gold exchange standard.
 Gold parity standard.
• But the only respect in which gold comes into play under
this system is that the currency authority takes upon itself
the obligation of maintaining the exchange rate of the
domestic currency stable in terms of a certain quantity of
gold.
• This is the type of gold standard which the member
countries of the I.M.F. are supposed to have. On January
16, 1975, however, the I.M.F. decided to abolish the
official price of gold.
• This put an end to the role that gold had played for 30
years in the international monetary system.
Gold parity standard.
 Advantages of Gold Standard
• It is an objective system and is not subject to changing policies of
the government or the currency authority.
• (ii) It enables the country to maintain the purchasing power of its
currency over long periods. This is so because the currency and
credit structure is ultimately based on gold in the possession of
the currency authority.
• (iii) Exchange-rate Stability. Another important advantage claimed
for the gold standard is that it preserves and maintains the
external value of the currency (rate of exchange) within narrow
limits. As a matter of fact, within the gold standard system, it
provides fixed exchanges, which is a great boon to traders and
investors. International division of labour is greatly facilitated.
 Advantages of Gold Standard
• It gives, in fact, all the advantages of a common international currency. It
establishes an international measure of value. As Marshall pointed out, “the
change to a gold basis is like a movement towards bringing the railway gauge
on the side branches of the world’s railway into unison with the main lines”.
This greatly facilitates foreign trade, because fluctuations in rates of exchange
hamper international trade.
• (v) Automatic Adjustment of Balance of Payments. It is further claimed that
gold standard helps to adjust the balance of payments between countries
automatically. How this happens may be illustrated by a simple example.
Suppose Great Britain and the U.S.A. are both on gold standard and only trade
with each other and that a balance of payments is due from Great Britain to
the U.S.A. Gold will be exported from the former to the latter.
• (vi) Gold Standard inspires confidence and contributes to national prestige, for
“so long as nine people out of ten in every county think the gold -standard is
the best, it is the best.”
 Disadvantages:
• Costly:
• Gold Standard is costly and the cost is unnecessary. We only want a medium of
exchange; why should it be made of gold? It is a luxury. ‘The yellow metal could
tickle the fancy of savages only’.
• 2. Not Stable:
• Even the value of gold has not been found to be absolutely stable over long periods.
• 3. Not Elastic:
• Under the gold standard, currency cannot be expanded in response to the
requirements of trade. The supply of currency depends on the supply of gold. But
the supply of gold depends on the success of mining operations which may have
nothing to do with the factors affecting the growth of trade and industry.
• 4. Not Automatic:
• Recently, even the gold standard has been a managed standard. The central banking
technique has been applied deliberately to control the working of the gold
standard. It is thus no longer automatic as it was claimed to be.
 Disadvantages:
5. Sacrifices Internal Stability:
Gold standard has also been charged with sacrificing internal stability to
external (exchange) stability. It is the interna­tional aspect of the gold standard
which has been paid more attention to.
6. Gold Movements Affect Investments.
Another disadvantage is that “gold movements lead to changes in interest
rates; so that investment is stimulated or checked solely in order to expand or
reduce money income”— (Benham).
7. No Independence.
Independent policy under this system is not possi­ble. A country on a gold
standard cannot follow an independent policy. In order to maintain the gold
standard or to restore it (as in Great Britain after World War I), it may have to
deflate its currency against its will. Deflation spells ruin to the economy of a
country. It brings, in its wake, large-scale unemploy­ment, closing of works and
untold suffering attendant on depression.
Paper Gold Standard or the SDR Standard
• Besides, the SDRs supplement gold dollars and pounds sterling which
most countries now use as monetary reserves.
• Thus, SDRs can be used unconditionally by the participating countries to
meet their liabilities, and they are not backed by gold.
• The resources of the new scheme are not a pool of currencies but simply
the obligation of participating members to accept the SDRs for the
settlement of obligations among themselves.
• Thus, SDRs serve as international money as good as other reserve
currencies.
• In January 1975, the IMF abolished the official price of gold and SDRs
have become instead the basis of the present international monetary
standard.
• Since the SDRs are not convertible into gold, the SDR standard may
alternatively be designated as Paper Gold Standard.
 Qualities of Good Monetary Standard

A sound monetary standard or system should possess

the following qualities.
1. Simplicity:
The monetary system should be simple and easily
understandable. A simple monetary system inspires
public confidence.
2. Elasticity:
A good monetary system should be elastic. It
should be capable of changing the money supply
according to the requirements of the economy.
3. Economical:
The monetary system should be economical. It should not require
heavy expenditure on its operation. An expensive monetary system is a
burden on the country. In this regard, paper money is better than the
metallic money.
4. Stability:
A good monetary system should ensure internal price stability and
external exchange rate stability. Stable internal price level is necessary
for the economic growth of the country and stability in the foreign
exchange rates is essential for the development of foreign trade.
5. Convertibility:
A sound monetary system must possess the quality of convertibility
of the currency into some expensive metal Convertible currency system
serves to inspire public confidence and facilitate interna­tional payments.
6. Legality:
A good monetary system must possess legal sanction; it must be
backed by the force of law. Legal tender money increases public
confidence and ensures general acceptability.
7. Automatic Working:
A good monetary system should have built- in-flexibility.
It should be capable of operating automatically without the
government intervention. According to Prof. Caiman, gold
standard was, “a fool-proof and knave-proof standard”.
There was no scope for artificial change in gold standard.
8. Economic Development:
An ideal monetary system must be helpful for a country
to achieve the objectives of economic development and
maximisation of employment.
9. Other Qualities:
A monetary standard should also possess some other
qualities like transferability, portability, cognizability,
uniformity, divisibility, etc
 NOTE ISSUE
• Note issue is the act by the government or
bank of printing a new amount of money and
making it available to use.
• The Reserve Bank of India is the sole authority
for the issue of currency in India.
• Note-issue or issue of currency notes is one of
the premier functions of central banks
including the RBI.
 Major Principles of Note Issue

• There are various principles of issue of

currency notes.
• Two common principles are
 the banking principle and
 the current principle.
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.
 The Banking Principle:

• 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 mone­
tary 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.
• 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.
 The Currency Principle:

• 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.
Five Alternative Systems of Note Issue:
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.
• 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.
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.
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.
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.
 Paper Gold Standard or the SDR Standard

• However, the fast changing circumstances

necessitated changes in the IMF system.
• In September 1967, the Board of Governors of the
IMF approved a plan for a new type of international
asset known as the SDRs (Special Drawing Rights).
• Under this Scheme, the IMF is empowered to
allocate to various member countries Special Drawing
Rights (SDRs) on a specified basis, which in effect
amounts to raising the limit up to which a member
country can draw from the IMF in time of need.
 What is SDR?
• The 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.
 BASKET OF CURRENCIES
• 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.
 What is the purpose of the SDR?

 The IMF created the SDR as a supplementary

international reserve asset in 1969, when
currencies were tied to the price of gold and
the US dollar was the leading international
reserve asset.
 The IMF defined the SDR as equivalent to a
fractional amount of gold that was equivalent
to one US dollar.
 FEATURES OF SDR
• When fixed exchange rates ended in 1973, the
IMF redefined the SDR as equivalent to the
value of a basket of world currencies.
• The SDR itself is not a currency but an asset
that holders can exchange for currency when
needed.
• The SDR serves as the unit of account of the
IMF and other international organizations.
 Who can hold SDRs?

• Individuals and private entities cannot hold SDRs.

• IMF members – and the IMF itself – hold SDRs and the IMF
has the authority to approve other holders, such as central
banks and multilateral development banks,
• while individuals and private entities cannot hold SDRs.
• As of February 2023, there were 20 organizations approved
as prescribed holders.
• Participating members and prescribed holders can buy and
sell SDRs.
 SDR value

• The SDR value in terms of the US dollar is determined daily

based on the spot exchange rates observed at around noon
London time. It is posted on the IMF website.
• The IMF reviews the SDR basket every five years, or earlier if
warranted, to ensure that it reflects the relative importance of
currencies in the world’s trading and financial systems.
• In the review concluded in 2015, the IMF’s Executive Board
decided that the Chinese renminbi
(RMB) met the criteria for inclusion in the SDR basket.
• In October 2016, the Chinese RMB joined the SDR basket and
the three-month yield for China Treasury bonds was added to
the basket used to set interest rates on SDRs.
Special Drawing Rights (SDRs)
 Characteristics of a Sound Monetary
Standard:
• It must be simple so that people can easily understand it. The
currency has to be used by all the people. If it is complicated,
the people will not understand it and will not be able to work
it well.
• (ii) A good currency system must help to keep prices
reasonably stable, thus toning down extreme fluctuations in
the purchasing power of the currency. Rapid price changes
are harmful to trade, industry and the people at large.
• (iii) It must also maintain the external value of the currency of
the country. If the ratio of the rupee with the foreign
currencies is maintained stable, India’s foreign trade would
flourish. Economists have, however, come to hold now that
the stability of internal prices is to be preferred to the stability
of foreign exchange ratio.
 Characteristics of a Sound Monetary
Standard:
• (iv) The system must be economical. The gold standard is a very
costly standard. That is the reason why it had to be given up. A
paper currency system supported by a type of standard money
and money of account in which the people of the country have full
confidence is an ideal system.
• (v) The system should be automatically elastic so that the currency
should expand when needed and contract when the need is over.
Only an elastic currency can best answer the needs of trade and
industry. When, as a result of rapid economic development, trade
expands, the currency must expand sufficiently.
• (vi) Finally, the currency system must inspire confidence. If the
people have no faith in it, they will not accept it.
 Indian System:
• The Indian currency system as a whole
commands the confidence of the people of
India.
• It is economical and reasonably steady
internally and internationally.
• It is also elastic.
• We can then safely assert that it is a good
monetary standard.
THANKYOU