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Role of Central Bank in Issue of Currency
One of the most important role of Central bank is issuing currency. For issuing currency, the Central bank has to maintain certain amount of reserves in the form of gold and foreign exchange.
This is to support the issue of currency and to maintain its value. As the banker to the issue, every currency issued by the Central bank is its liability, because it is nothing but a promissory note. This liability has to be balanced by an equal amount of asset. Hence, the banks maintain certain amount of asset in the form of gold and foreign currency. Thus, the Central bank adopts different types of note issue.
Major Principles of note issue by Central Bank
There are two major principles of note issue which are
- Currency Principle.
- Banking Principle.
1. Currency Principle
Under the currency principle, the Central bank is supposed to back the issue of currency with an equal amount of gold and foreign currency.
2. Banking Principle
In banking principle, like the commercial banks, the Central bank will keep a certain percentage of gold and foreign currency for backing the entire note issue. We see in the day-to-day banking business that the commercial banks do not keep the entire depositors’ money as cash in hand.
Only a small portion of the depositors’ money is used for cash in hand and the rest is given as loan. The same way, under the banking principle of note issue, with limited amount of gold and foreign currency reserves, the Central bank resorts to issue of more currency.
Types of notes issue under banking principle
Under the banking principle, we have different types of note issue which are
- Maximum fiduciary system.
- Fixed fiduciary system.
- Proportional reserve system.
- Minimum reserve system.
1. Maximum fiduciary system
Maximum amount of currency will be issued without the backing of gold and foreign currency. This system gives maximum powers to Central bank and this was adopted by France till 1928.
2. Fixed fiduciary system
Under this system, only a fixed amount of notes can be issued without any backing of gold and foreign currency. The issue of currency beyond the system will be backed by equal amount of gold and silver. England was adopting this system under the Bank Charter Act of 1844. Under this system, the currency is convertible into gold after a particular level.
3. Proportional reserve system
Here, the note issue on a percentage basis will be backed by gold and other securities such as foreign currency, say, 40% with gold and 60% with foreign currency. This percentage will vary according to the availability of gold and foreign currency. India adopted this system till 1956.
4. Minimum reserve system
Under this system, a minimum amount of gold and foreign currency will be maintained and the rest of the currency will be backed by government securities. In India, Rs. 200 crores is the minimum reserve limit which will have Rs. 115 crores of gold and the rest Rs. 85 crores in foreign currency. This gives enough elasticity for increasing the supply of currency. But RBI cannot issue any amount of currency, as beyond the limit of Rs. 200 crores, there should be other security such as government treasury bills, to back the issue of money.