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Week 6 - Monetary Standards.

I. Monetary Standards Overview

  • Definition: A framework or set of principles a nation follows to define the value of its currency and regulate money supply.

  • Basis: Can be Commodity Standard (linked to tangible assets like gold/silver) or Fiat Standard (based on government authority).

  • Key Objectives:

    1. Maintain Internal Price Stability (control inflation/deflation).

    2. Maintain External Price Stability (stable exchange value).

  • Importance:

    • Homogeneity: One currency note equals another in value and appearance.

    • Gresham's Law: A good standard avoids the circulation of "bad money" driving out "good money" (though this law specifically operates when standards fail or clash).

II. Metallic Standard

  • Definition: Currency value is directly tied to a specific metal (Gold or Silver).

  • Two Main Types:

    1. Monometallism: Value based on one specific metal.

    2. Bimetallism: Value based on two metals (usually Gold and Silver).

A. Monometallism

  • Features:

    • Standard coins defined by one metal.

    • Unlimited Legal Tender for day-to-day obligations.

    • Free Coinage: Public can convert metal into coins at the mint.

    • No restrictions on import/export of the metal.

  • Types of Monometallism:

    1. Silver Standard:

      • Standard unit defined in terms of silver.

      • Indian Context: India was on the Silver Standard from 1835 to 1893.

      • Rupee Specs: Weight fixed at 180 grains; Fineness 11/121.

      • Drawback: Silver price fluctuates more than gold, leading to instability.

    2. Gold Standard:

      • Most popular form historically.

      • Adoption History:

        • U.K.: First to adopt in 1816; abandoned in 19312.

        • Germany: 1873.

        • France: 1878.

        • U.S.A.: 1900.

      • Definitions:

        • D.H. Robertson: "State of affairs where value of monetary unit and defined weight of gold are kept at equality."

        • Kemmerer: "Unit of value consists of value of a fixed quantity of gold in a free gold market."

  • Merits: Simple, public confidence, avoids Gresham's Law (since only one metal exists).

  • Demerits: Inelastic (supply depends on metal reserves), Costly, lacks price stability if metal value changes.

B. Bimetallism

  • Definition: System where currency is based on a fixed ratio between two metals (Gold & Silver).

  • Types:

    1. Free Bimetallism:

      • Unlimited coinage of both metals.

      • Market determines usage based on established rate.

      • "Free Silver" Movement: Late 19th-century US movement calling for unlimited silver coinage to fight deflation and help farmers/debtors 3.

    2. Managed Bimetallism:

      • Government actively controls the value relationship/ratio to ensure stable coexistence.

      • Aims to prevent Gresham’s Law (where one metal becomes undervalued/overvalued).

  • Merits:

    • Convenience: Gold for large transactions, Silver for small ones.

    • Stability: Shortage of one metal can be offset by the other.

    • Low Interest Rates: Larger money supply generally lowers rates.

  • Demerits:

    • Gresham’s Law: If Mint Rate \(\neq\) Market Rate, Bad Money (overvalued at mint) drives out Good Money (undervalued at mint) 4.

    • Speculation: Encourages trading on metal price fluctuations.

III. Paper Standard (Fiat Standard)

  • Definition: Inconvertible paper currency used as unlimited legal tender.

  • Status: Adopted globally after the collapse of the Gold Standard in 1931.

  • Features:

    • No Gold Backing: Currency is not convertible into metal.

    • Managed Standard: Authority regulates quantity to maintain stability.

    • National Character: No automatic link between different countries' paper systems.

  • Merits:

    • Elastic Money Supply: Can be adjusted easily by authorities (unlike metallic).

    • Cost-Effective: No need to maintain expensive metal reserves.

    • Avoids Deflation: Prevents money contraction caused by gold outflows.

    • Emergency Utility: Useful for financing wars or deficits.

  • Demerits:

    • Exchange Instability: Rates fluctuate significantly without a metal anchor.

    • Inflation Danger: Risk of over-issuance by governments to cover deficits.

    • Management Risk: Relies heavily on efficient management; mistakes lead to crises.

IV. Minimum Reserve System (India)

  • Adoption: In use in India since 19565.

  • Regulation: Governs how RBI prints currency notes.

  • Requirement: RBI must maintain a minimum reserve of ₹200 Crores at all times.

    • Gold/Gold Bullion: Minimum ₹115 Crores6.

    • Foreign Currencies: Balance ₹85 Crores7.

  • Operation: After maintaining this reserve, RBI can print an unlimited amount of currency (with Govt approval)8.

  • Promise: The "I promise to pay the bearer..." clause on notes reflects the guarantee backed by this system.