Note Issue Function of Central Bank | Principles, System, Method

[ Principles of Note Issue. Currency Principle. Banking Principle. Methods of Note Issue. Simple Deposit System. Fixed Fiduciary System. Minimum Reserve System. Comparison. Fixed Fiduciary System vs Maximum Fiduciary System. Full Reserve System Vs Fixed Fiduciary System. Which is the best method? Which is the worst method? ]

The central bank issues currency on the basis of principles and methods. In this article I am going to write about the principles and methods of issuing notes by central banks.

Principle of Note Issue:

Central banks follow two principles for note issue. One is currency principles and the other is banking principle. In this section I am going to write about both of them.

Currency Principle:

According to this principle central bank must issue currency against gold reserve or any kinds of reserve. The condition of the reserve is that the central bank can easily convert the reserves into cash at the time of urgent need. This principle is safer but create inelasticity.

Banking Principle:

According to this principle central bank must issue currency on the basis of demand unlikely to the currency principle. This principle tells us that we calculate how much money flow we need and then we supply the cash on the market. This Principle is very elastic and very risky as it will definitely cause inflation due to the over issuance of the currency.  

Methods of Note Issue:

Simple Deposit System or Full Reserve System:

1. The monetary authority mainly the central bank must have reserve for issuing currency.
2. Money supply can't be increased more than the reserve even at the time of urgent need.

For Example: A is a country. It has 1000 Tonnes of gold. The monetary authority of that country can issue currency only on the gold. So they follow simple deposit system or full reserve system. 

Fixed Fiduciary System:

1. The monetary authority issues currency on the gold reserve. 
2. Give Permission to issue specific amount of currency without gold reserve

For Example: B is a country. It has 1000 tonnes of gold. They issued 10% more currency than the reserve they have. So, they follow fixed fiduciary system.

Maximum Fiduciary System:

1. The limit is fixed above the normal requirements
2. If the limit is too low the currency system becomes inelastic
3. If the limit is too high, there is a danger of over issue of notes.

For Example: C is a country. It has 1000 tonnes of gold. The central bank issued 100% on gold reserve. But following an urgent need bank set the maximum limit up to which they can issue currency. For example they can issue at most 20% beyond reserve.

Proportional or Percentage Method:

1. Certain proportion of the reserve has to maintain in the form of precious metals like gold.
2. Remaining part of the reserve is to be kept by Government securities or commercial bills. (Central Bank Buys It)

For Example: D is a country. It issue currency on reserve. But it issue currency on only two types of reserve. One is gold and another is government security. They issue 70% on gold and remaining 30% on government securities and commercial bills. So, they follow percentage method. 

Minimum reserve system:

1. Government can issue notes up to any amount against the reserve.
2. There is a very high risk of inflation.

For example: E is a country. It's central bank set the amount of reserve on how much it can issue currency. It set that it can issue only on 60% of its total reserve. Rest of the amount is on the demand of notes.

Fixed Fiduciary System vs Maximum Fiduciary System:

I confused these two with one another. So, I will clear these two part in this section. Fixed fiduciary system means that the central bank will issue currency on the reserve but it can also issue more. On the other hand Maximum Fiduciary System means that central bank issues currency on the reserve but has a limit up to which it can issue currency without reserve. So after all kind of evaluation we can say that fixed fiduciary system clearly says that the CB will issue currency on 10% or 20% without reserve where fixed fiduciary system doesn't clearly says that what amount they can issue but set a range up to which they can issue money. 

Full Reserve System Vs Fixed Fiduciary System:

Full reserve system means that CB can issue currency only on metalic reserve such as gold, silver etc,  where Fixed Fiduciary System allows the Central Bank to issue currency without reserve for a certain limit. 

Which is the worst method?

Minimum Reserve method is the worst method of note issue. It create great risk of inflation as it allows the central bank to issue currency without any base or reserve. The usage of this method has been reduced greatly.

Which is the best method? 

It depends on the situation. Right now proportionate method is very popular. The central bank doesn't have to issue currency on total reserve and it allows the central bank to issue currency on government bond and commercial bills. This system is both elastic and secured.

Is there any method which will last forever?

If we look at the history of the method of note issue, we can see that none of these methods application lasted forever because every methods have limitation. New methods evolved and invented to solve the issues. So, to answer the question, I can say no. These methods will always evolve. For example the latest method is the percentage method. Many country still face inflation problem, which took place because of over issue of currency. So, they may apply different method to overcome the issue.

Conclusion:

I hope this is enough for today. These are the most widely used methods of note issue. Use of some of them is stopped because of some problem. Now the most widely used method is proportional or percentage method. I hope you have understood this lesson. If there is any confusion please write it on the comment section.

End.