Saturday, August 22, 2009

Advantages and Disadvantages of Paper Currency Standard

Paper currency standard consists of paper money which is unlimited legal tender and token coins of cheap metals. Paper money may be either convertible of inconvertible. Convertible paper money is convertible into gold or silver coins or bullion of specified weight on demand. Paper money is not convertible into coins of a precious metal of bullion nowadays. Therefore it is inconvertible. People accept it because it is legal tender. Since it has the command of the government, people have to accept it. That is why it is also known as ‘fiat money’ or standard. It is also referred to as managed standard because the issue of paper money and token coins is managed by the central bank of the country.
The paper currency standard which is universally used, has a number of merits. Some of these are stated below.
1. Economical: The paper currency standard is cheaper than the gold or silver for coinage purpose. Rather precious metals can be used for productive purposed and for making payments for foreign countries. As paper money is not convertible, there is no need to keep gold in the form of reserves. The money authorities keep only a fixed quantity of gold in reserve for reasons of security. Thus paper standard is cheap and economical and even a poor country can easily adopt it.
2. Elastic: The paper standard is a highly useful. Monetary system because it possesses great elasticity. The monetary authority can easily adjust the money supply in accordance with the requirements of the economy. This was not possible under the gold standard. The supply of money can be increased by printing more notes in times of financial emergency, war and for economic development. It can also be reduced when the economic situation so demands. Thus there is also freedom in the management of the money supply in the economy.
3. Price Stability: The paper standard ensures price stability in the country. The monetary authority can stabilise the price level by maintaining equilibrium between demand and supply of money by an appropriate monetary policy.
4. Free from Cyclical Effects: The paper standard is free from the effects of business cycle arising in other countries. This merit was not available to other monetary standards, especially the gold standard, where cyclical movements in one country were automatically passed on to other countries through gold movements.
5. Full Utilisation of Resources: The gold standard had a deflationary bias where by the resources of the country remained unutilised. Whenever there was gold out of flow, the prices fell and resources became unemployed. But this is not the case under the paper standard in which the necessary authority can manipulate the monetary policy in order to ensure full utilization the country’s resources,
6. Equilibrium in Exchange Rate: One of the merits of the paper standard is that it immediately restores equilibrium in the exchange rate of a country whenever disequilibrium occurs in the demand and supply of its currency in the foreign exchange market.
7. Portable: It is very convenient to carry large sums of paper money from one place to another.
8. Easy to count: It is easier count paper money than metallic money.
9. Easy to store: It is easier to store large sums of paper money in a small space.
10. Cognisable: It is easy to recognise paper notes of different denomination.
11. Replaceable: Paper notes of one type and denomination can be easily replaced by printing notes on different types of the same denomination.
Despite above mentioned merits, the paper currency standard has certain disadvantages, these disadvantages are mentioned below.
1. Inflationary Bias: One of the serious defects of the paper standard is that it has an inflationary bias. As paper notes are inconvertible, there is every likely hood of the government printing note in excess of requirements. Or the government may deliberately resort to the printing press to meet a financial emergency or war or even to need ordinary budget deficits. This leads to excess of money supply and to inflation in the country.
2. Price Stability a Myth: In the merits of the paper currency standard it has been pointed out that it leads to price stability. Actually price stability is a myth as has been experience of the majority of the countries on the paper standard.
3. Exchange Instability: Another disadvantage of this system is that it leads to instability in exchange rates whenever there are large fluctuations in external prices an against internal prices. Such wide and violent fluctuations in exchange rates are harmful for the growth of international trade and capital movements among countries. These have led governments to adopt exchange control measures.
4. Lacks Confidence: Paper money lacks confidence as it is not backed by gold reserves.
5. Lacks Durability: Paper money has less durability than metallic coins. It can be easily destroyed by fire or insects.
6. Unstable: Paper money lacks stability because its supply can be changed easily.
7. Uncertainty: Instability in the value of paper money leads to uncertainty in the economy which adversely affects business and economic progress of the country,
8. Token Money: Paper money is token money and in the event of demonetisation of notes they have no intrinsic value and are simply like wrote papers.
9. Not Automatic: The paper currency standard does not operate automatically. It is highly managed standard which requires much care and caution on the parts of the monetary authority. A little carelessness may bring disaster to the economy.
Broadly speaking, a sound currency system must fulfil the following conditions.
(i) It must maintain reasonable stability of the prices in the country. This means that its internal value (or purchasing power in terms of goods and services in country concerned) must not fluctuate too violently. This involves regulation of amount of money in circulation to suit the requirements of the trade and industry in the country.
(ii) 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. This is the problem of foreign exchange.
(iii) The system must be comical. A costly medium of exchange is a national waste. It is unnecessary. That is why all countries use mostly paper money.
(iv) The currency must be elastic and automatic so that it expands or contracts in response to the requirements of trade and industry.
(v) The currency system must be simple so that an average man can understand it. A complicated system cannot inspire public confidence.


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