Saturday, August 22, 2009

Essentials of Good Monetary System

Various monetary systems or standards have been adopted in practice from time to time. Broadly speaking a good monetary system must fulfil the following conditions.
(i) It must maintain a reasonable stability of prices in the country. This means that its internal value (or purchasing power in terms of goods and services in the country concerned) must not fluctuate too violently. This involves regulation of amount of money in circulation to suit the requirements of trade and industry in the country.
(ii) A good monetary system must maintain stability of the external value of the currency. This means that its purchasing power over goods and services in foreign countries, thought its command over a definite amount of foreign currency, should remain constant. This is the problem of foreign exchange.
(iii) The monetary system must be economical. A costly medium of exchange is a nation 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 monetary system must be simple so that an average man can understand it. A complicated system can not inspire public confidence.
In modern times metallic money is supplemented or replaced by paper money altogether. Paper money has been very useful. It economises the use of precious metals. It is convenient to carry and easy to store. Its value can be kept stable by properly controlling its issue. It is of great fiscal advantage to the government. A government can tide over a period of difficulty by the issue of paper money.
In early times when notes were introduced, they were backed by an exactly equal amount in gold or silver exchanged for coins whenever needed and did nothing more than represent coins. They were called representative paper money. American gold certificates (Green backs) were of this type. This practice was very expensive and is no more current now.
Paper money is not wholly backed by specie (i.e. precious metal) now. Only proportional reserves are maintained and a good deal of paper money rests on people’s confidence in the world of the issuing authority, be it Government or the Central Bank of the country.
Paper money can be convertible or inconvertible. If the issuing authority promises to convert notes into standard money on demand, it is called convertible paper money. But something after an over issue of paper money in an emergency like war, the authority feels unable to convert its notes into coins. Then it breaks its promise of converting notes into standard money and there by makes the money inconvertible or fiat money (money by order). When the link with metal is broken there is tendency to over issue paper money. Its value then depreciates. Prices shoot up, which results in suffering for people with fixed incomes.
Essentials of good monetary system found in Paper currency standard are mentioned below.
Practically paper money costs nothing to the Government currency notes, therefore are the cheapest media of exchange. If a country uses paper money, it need not spend anything on the purchase of gold or silver for minting coins. The loss which a country suffers from the wear and tear of metallic money is also avoided.
The paper money is most convenient form of money. A large amount can be carried conveniently in the pocket without any body knowing it.
Fiscal advantages of the paper currency to the Government are undoubtedly very great especially in the times of national emergencies like a war. A modern war cannot be prosecuted by taxes or loans alone. All governments have to resort to printing press.
The paper standard is 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. 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 situation demand so.
As a corollary to above, the paper standard ensures the price stability. The monetary authority can stabilise the price level by maintaining equilibrium between demand and supply of money by an appropriate monetary policy.
The paper standard is free from the effect of business cycles arising in other countries.
The gold standard had a deflationary bias, whereby the resources of the country remained utilised. Whenever there was gold in outflow, 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.
One of the advantages of the paper currency 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.
Paper notes of one type and denomination can be easily replaced by printing notes of different types of the same denomination.


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