Unit 3
Monetary Standards
A monetary standard is a set of institutions and rules governing the supply of money in an economy. These rules and institutions collectively constrain the production of money. Through its constraints on money creation, the standard indirectly acts on prices. A monetary standard may also affect the rate of growth of real economic output, but that depends on expectations. Monetary institutions may also affect other economic institutions, which themselves influence economic growth.
Monetary standards are the set of rules and institutions that control the supply of money in a country’s economy. The idea is to have rules and regulations in place to constrain the production and supply of money. Otherwise, with excess money in the market, the whole balance of the economy will be destroyed.
One definition of monetary standards is “the principles way of regulating the quantity of money in the market as well as its exchange value”. So monetary standards also have an indirect effect on the prices in the economy. And by monitoring the supply of money, it also has an effect on the rate of growth in the economy and other factors that affect such economic growth.
Types of Monetary Standards
Overall, there can be two main kinds of monetary standards – metallic standards or paper standard. Metallic standards themselves can be of two types – monometallism and bimetallism. Let us take a more detailed look at the types of monetary standards.
1] Monometallism
Also known as Single Standard, here only one metal is adopted as the standard currency/money. The monetary system is made up of and relies entirely on one metal, like say the gold standard or the silver standard. So, coins are made up of one metal only.
This means these coins are the legal tender for all day-to-day transactions. There is unlimited manufacture of coins, i.e., free coinage.
2] Bimetallism
As the name suggests, in the double standard or bimetallism system, two metals are adopted as standard money. There is a fixed legal ratio between the value of the two metals to facilitate exchange. Usually, the two metals are gold and silver. So, two types of standard coins are minted (gold and silver).
So, under bimetallism, two types of metal coins are in circulation simultaneously in the economy. Both have free coinage. And using the legal ratio of exchange both are convertible into each other. One main advantage of this system is that the economy has a full-bodied currency. Silver can be used for the smaller transactions and gold for the bigger ones.
3] Paper Currency Standard
Under this monetary standard, the currency prevailing in the economy will be paper currency. In most cases, this currency system is managed by the Central Bank of the country, RBI in the case of India, and so we can also call it Managed Currency Standard. The currency consists of bank notes and government notes.
Most countries of the world follow this monetary standard. This is because it is a managed and controlled system. So, an authority will monitor the quantity of money supply keeping in mind the stability in prices and income in the economy. It is also very economical in terms of production (currency notes). And they are far more convenient than metallic standards.
The expression “Gresham's Law” dates back only to 1858, when British economist Henry Dunning Macleod (1858, p. 476-8) decided to name the tendency for bad money to drive good money out of circulation after Sir Thomas Gresham (1519-1579).
Gresham's law is a monetary principle stating that "bad money drives out good." It is primarily used for consideration and application in currency markets. Gresham’s law was originally based on the composition of minted coins and the value of the precious metals used in them. However, since the abandonment of metallic currency standards, the theory has been applied to the relative stability of different currencies' value in global markets.
Understanding Good Money vs. Bad Money
At the core of Gresham’s law is the concept of good money (money which is undervalued or money that is more stable in value) versus bad money (money which is overvalued or loses value rapidly). The law holds that bad money drives out good money in circulation. Bad money is then the currency that is considered to have equal or less intrinsic value compared to its face value. Meanwhile, good money is currency that is believed to have greater intrinsic value or more potential for greater value than its face value. One basic assumption for the concept is that both currencies are treated as generally acceptable media of exchange, are easily liquid, and available for use simultaneously. Logically, people will choose to transact business using bad money and hold balances of good money because good money has the potential to be worth more than its face value.
Origins of Gresham's Law
The minting of coins provides the most basic example of Gresham’s law applied. In fact, the law’s namesake, Sir Thomas Gresham, was referring to gold and silver coins in his relevant writing. Gresham lived from 1519 to 1579, working as a financier serving the queen and later founding the Royal Exchange of the City of London. Henry VIII had changed the composition of the English shilling, replacing a substantial portion of the silver with base metals. Gresham’s consultations with the queen explained that people were aware of the change and began separating the English shilling coins based on their production dates to hoard the coins with more silver which, when melted down, were worth more than their face value. Gresham observed that the bad money was driving out the good money from circulation.
This phenomenon had been previously noticed and written about in ancient Greece and medieval Europe. The observation was not given the formal name "Gresham's law" until the middle of the 19th century, when Scottish economist Henry Dunning Macleod attributed the it to Gresham.
How Gresham's Law Works
Throughout history, mints have made coins from gold, silver, and other precious metals, which originally give the coins their value. Over time, issuers of coins sometimes reduced the amount of precious metals used to make coins and tried to pass them off as full value coins. Ordinarily, new coins with less precious metal content would have less market value and trade at a discount, or not at all, and the old coins would retain greater value. However, with government involvement such as legal tender laws, the new coins would typically be mandated to have the same face value as older coins. This means that the new coins would be legally overvalued, and the old coins legally undervalued. Governments, rulers, and other coin issuers would engage in this in order to obtain revenue in the form of seigniorage and pay their old debts (which they borrowed in old coins) back in the new coins (which have less intrinsic value) at par value.
Because the value of the metal in old coins (good money) is higher than the new coins (bad money) at face value, people have a clear incentive to prefer the old coins with higher intrinsic precious metal content. As long as they are legally compelled to treat both types of coins as the same monetary unit, buyers will want to pass along their fewer precious coins as quickly as possible and hold on to the old coins. They can either melt the old coins down and sell the metal, or they may simply hoard the coins as a greater stored value. The bad money circulates through the economy, and the good money gets removed from circulation, to be stashed away or melted down for sale as raw metal.
The end result of this process, known as debasing the currency, is a fall in the purchasing power of the currency units, or a rise in general prices: in other words, inflation. In order to fight Gresham’s law, governments often blame speculators and resort to tactics like currency controls, prohibitions on removing coins from circulation, or confiscation of privately owned precious metal supplies held for monetary use.
In a modern example of this process, in 1982, the U.S. Government changed the composition of the penny to contain 97.5% zinc. This change made pre-1982 pennies worth more than their post-1982 counterparts, while the face value remained the same. Over time, due to the debasement of the currency and resulting inflation, copper prices rose from an average of $0.6662/lb. In 1982 to $3.0597/lb. In 2006 when the U.S. Imposed stiff new penalties for melting coins. This means that the face value of the penny lost 78% of its purchasing power, and people were eagerly melting down old pennies, which were worth almost five times the value of the post-1982 pennies by that point. The legislation leads to a $10,000 fine and/or five years in prison if convicted of this offense.
The paper standard is cheaper than gold or silver standard. There is no need to waste gold or silver for coinage purposes. Rather precious metals can be used for productive purposes and for making payments to foreign countries. As paper money is not convertible, there is no need to keep gold in the form of reserves.
Paper standard consists of paper money which is unlimited legal tender and token coins of cheap metals. Paper money may be either convertible or 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 now-a-days.
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.
Advantages of paper standard
1. Economical:
The paper standard is cheaper than gold or silver standard. There is no need to waste gold or silver for coinage purposes. Rather precious metals can be used for productive purposes and for making payments to foreign countries. As paper money is not convertible, there is no need to keep gold in the form of reserves. The monetary authorities keep only a fixed quantity of gold in reserve for reasons of security. Thus, the 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:
As a corollary to the above, 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 cycles 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 whereby the resources of the country remained unutilized. Whenever there were gold outflow prices fell and resources became unemployed. But this is not the case under the paper standard in which the monetary authority can manipulate the monetary policy in order to ensure full utilisation of 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 to 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 denominations.
11. Replaceable:
Paper notes of one type and denomination can be easily replaced by printing notes of different types of the same denomination.
Demerits of the Paper Standard:
Despite these merits, the paper standard has certain disadvantages:
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 likelihood of the government printing notes in excess of the requirements. Or, the government may deliberately resort to the printing press to meet a financial emergency or war or even to meet ordinary budget deficits. This leads to excess of money supply and to inflation in the country.
2. Price Stability a Myth:
It has been pointed out in the merits of the paper standard that it leads to price stability. In actuality, price stability is a myth as has been the experience of the majority of 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 as 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.
8. Token Money:
Paper money is token money and in the event of de-monetisation of notes, they have no intrinsic value and are simply like waste paper.
9. Not Automatic:
The paper currency standard does not operate automatically. It is a highly managed standard which requires much care and caution on the part of the monetary authority. A little carelessness may bring disaster to the economy.
There are various principles of issue of currency notes. Two common principles are the banking principle and the current principle. These two principles governed the issue of notes in former times, but at present various other principles have been evolved.
- The Banking Principle:
It is not at all necessary to establish clear-cut rules and regulations regarding reserve. This is the essence of the banking principle. The banking school argued that, given that bank notes were convertible into gold, there was no need to regulate note issue because the fact of convertibility would prevent any serious over-issue.
Moreover, it was pointless to try to regular the issue of bank notes because the demand for currency would be met by an expansion of bank deposits, which would have the same effect as an expansion of the note issue.
The only major advantage of this principle is that the monetary system, based on this principle, would be economic and elastic. There is no need for gold or silver backing to support the issue of currency notes.
Disadvantages:
However, the currency system based on this principle would be wasteful and uneconomic. The reason is easy to find out. Since a huge amount of metal has to be kept as reserve to provide the necessary backing the system would appear to be unproductive and costly, too.
The second disadvantage of the principle is that currency (monetary) system based on gold would inherently inelastic in as much as the volume of notes could be increased or decreased according to the changing requirements of the country.
Instead, the quantity of money in circulation world depends entirely on the existing stock of gold (or any other precious metal) chosen to from the reserve base of the system. If the economy is not at full employment the quantity of money would be grossly inadequate to step up aggregate demand to such a level as to enable the economy achieve full employment.
In other words, in most real-life situations of less-than-full employment the stock of money in circulation would be less than what is required to produce the economy’s potential (i.e., full employment) output.
Five Alternative Systems of Note Issue:
In practice, every country has developed its own method of controlling the issue of currency notes. But no country in the world which has gone to the extent of adopting a hundred percent reserve as dictated by the currency principle.
The various systems of note issue prevailing in different countries of the world can be divided into five broad categories.
1. The Fixed Fiduciary System:
This is one of the oldest systems of controlling note issues. Under this system, a country can issue a certain quantity of notes without any reserve, (i.e., without gold or silver backing). The upper limit to this quantity is called fiduciary limits beyond which there has to be a hundred percent metallic reserve. Over the years, the system was following many other countries. However, the fiduciary limit had to be raised from time to time in order to meet the growing needs of trade and industry.
The system has both merits and drawbacks:
Advantages:
This method enables the central bank to exercise strict control over note issue which is important for controlling inflation or maintaining stability in the value of a currency. So, this method instils confidence among people as it did when it operated in the U.K. In the past.
Disadvantages:
However, this method has several drawbacks:
(i) Wastage:
Firstly, the system appeared to be uneconomical as it locked up a huge quantity of gold unnecessarily.
(ii) Inelasticity:
Secondly, the system proved to be inelastic. Money supply could not be increased easily even when trade and industry expanded.
2. The Maximum Limit System:
This system was adopted in France and was in operation up to 1928 (just a year before the great crash of 1929). Under the system the State fixed an upper limit to note-issue without any reserve. But any issue of notes beyond the limit was possible only after obtaining necessary legal sanction, i.e., permission from the legislature.
Advantages:
Two advantages of the system are:
(i) Freedom:
The most important thing to be said in favour of the system is that under it the note- issuing authority enjoys complete freedom (or full discretion) as regards reserve.
(ii) Economy:
Secondly, the system is economical in the sense that the reserve of gold kept in an unproductive from can be reduced to a minimum.
Disadvantages:
Two disadvantages of the system are:
(i) Inelasticity:
If the upper limit to note issue is fixed at a very low level the system of such issue suffers from inherent inelasticity. This is likely to create problems in periods of expanding economic activity.
(ii) Inflation:
In contrast, if the limit is fixed at too high a level there is the danger of price inflation — too much money chasing too few goods.
3. The Proportional (Fractional) Reserve System:
Most countries of the world have now adopted the fractional reserve system. Under this system note issue is conditioned by gold backing (varying from 25 to 40%). This means that a certain portion of note-issue has to be backed by gold reserve.
The remaining part of the note issue has to be covered by government securities (which are highly liquid assets) and approved commercial papers. There is also the general provision that subject to certain conditions and penalties the reserve rate may be permitted to fall below the legal minimum.
Advantages:
Two main advantages of this system are:
(i) Simplicity:
The first thing to be said in favour of the proportional reserve system is that it is simple to operate.
(ii) Elasticity:
The second advantage offered by the system is that it is elastic.
Disadvantages:
The main disadvantages of this system are:
(i) Uneconomic nature:
The most important defect of the system is that it is not economical. The reason is that an unproductive gold reserve has to be kept.
(ii) Multiplier effect:
Secondly, the system creates reverse multiplier effect. In the event of a fall in the central bank’s stock of gold, the note-issue contracts more than in proportion. This is likely to have contractionary effects on trade and industry. At the end the economy is likely to be in a cumulative deflationary spiral.
(iii) Inadequacy:
Finally, the system proves to be useless in times of financial crisis because the gold reserve is considerably less than the total note-issue.
If people lose confidence in currency notes in times of crisis, the reserve becomes grossly inadequate to liquidate all the notes. If the system is able to generate confidence among people, the reserve is unnecessary. However, as a general rule, it seems that the existence of a partial reserve is quite sufficient to create confidence among the people at large.
4. The Proportional Reserve Not Based on Gold:
In most developing countries like India there is no doubt a legal provision for maintaining a certain percentage of note-issue in the form of reserve, which can be held partly in gold and partly in foreign currencies. Such a system was set up in India in 1956.
Advantages:
Three main advantages are:
(i) Economy:
The chief advantage of the system is that it is economy. The reason is that a part of the reserve can be held in the form of (foreign) interest bearing securities.
(ii) Elasticity:
It is highly elastic in nature.
(iii) Exchange rate stability:
Finally, it enables the central bank to maintain stability in the external value of the country’s currency. When, for instance, a country suffers from a deficit in the balance of payments the external value of its currency tends to fall.
This can be prevented by selling foreign currencies. In contrast, when a country enjoys a surplus in its balance of payments, the external value of the country’s currency tends to rise. In such a situation the rate of exchange can be kept steady by purchasing foreign currencies.
Disadvantages:
The disadvantage of this system is inflation: The most serious weakness of the system is that it has an inherent inflationary potential. If money supply increases due to inflow of foreign exchange (when the balance of payments position is favourable) but the supply of goods and services fails to increase proportionately prices will rise and the value of money will fall.
Conclusion:
On the balance it seems that foreign exchange reserves, if judiciously used, can be a source of strength, not weakness, of the monetary system. But it is not always proper to hold the foreign balance as part of the legal reserve against note issue. It is necessary to draw a distinction between reserves held for exchange rate stabilisation and reserves held as reserve against notes issued for internal circulation.
5. The Minimum Reserve System:
Finally, we may refer to the minimum reserve system under which the central bank can issue notes without limit against government securities and approved commercial papers but is under the legal obligation to keep a minimum reserve of gold and foreign currencies. Such a system has been operating in India since 1956.
Advantages:
Two main advantages of this system are:
(i) Elasticity and flexibility:
The most important advantage of the system that it imparts a high degree of elasticity and flexibility to the system of note-issue. The power to issue notes can be used for deficit spending if and when it is needed for development purposes.
India adopted this system for a two-fold reason:
(a) To use foreign securities (formerly kept as reserve against note-issue) in order to meet the foreign exchange requirements of the. Five Year Plans and
(b) to facilitate inflationary financing.
(ii) Raising resources:
Secondly, the minimum reserve system is particularly suitable for developing countries like India which have relied on the planning system for achieving faster economic growth. The need to raise resources to finance the plans is much more important in such countries than keeping a huge amount of unproductive reserves with the central bank.
Disadvantages:
Two disadvantages of the system are:
(i) Inflationary potential:
Prima facie, the system is highly dangerous because of its inherent inflationary potential. It breeds inflation by making it quite easy for the government to raise reserves by printing paper currency.
(ii) Public option:
Secondly, the system completely ignores the role of currency reserves in maintaining people’s confidence in the monetary system of the country.
Critics point out that the system will prove to be successful only under a strong government (free from corruption) which is determined to follow a sound economic policy and is successful in tilting public opinion in its favour.
Conclusion:
It is very difficult to say which of the above systems of regulating note issue is the best. It all depends on the particular economic circumstances of the country concerned. An ideal system is one which seeks to secure four major objectives: (1) economy, (2) elasticity, (3) safety and (4) stability. The emerging trend today in most developing countries is towards the adoption of a reserve system which is sufficiently flexible to meet their developmental needs.
Gold standard, monetary system in which the standard unit of currency is a fixed quantity of gold or is kept at the value of a fixed quantity of gold. The currency is freely convertible at home or abroad into a fixed amount of gold per unit of currency.
The gold standard is a currency measurement system that uses gold as a way to set the value of money. It ensures that currency under a gold-standard system can be exchanged for gold. The gold standard signifies an agreement between society and its monetary institutions that the currency they spend and earn is a stand-in for gold.
To fully grasp the gold standard, it's important to understand how gold has been used for centuries to set the standard for currency value, why it's fallen out of favour, and its pros and cons.
The gold standard is not currently used by any government. Britain stopped using the gold standard in 1931 and the U.S. Followed suit in 1933 and abandoned the remnants of the system in 1973.
The gold standard was completely replaced by fiat money, a term to describe currency that is used because of a government's order, or fiat, that the currency must be accepted as a means of payment. In the U.S., for instance, the dollar is fiat money, and for Nigeria, it is the naira.
The Gold Standard: A History
"We have gold because we cannot trust governments," President Herbert Hoover famously said in 1933 in his statement to Franklin D. Roosevelt. This statement foresaw one of the most draconian events in U.S. Financial history: the Emergency Banking Act, which forced all Americans to convert their gold coins, bullion, and certificates into U.S. Dollars. While the legislation successfully stopped the outflow of gold during the Great Depression, it did not change the conviction of gold bugs, people who are forever confident in gold's stability as a source of wealth.
Gold has a history like that of no other asset class in that it has a unique influence on its own supply and demand. Gold bugs still cling to a past when gold was king, but gold's past also includes a fall that must be understood to properly assess its future.
The Rise of the Gold Standard
The gold standard is a monetary system in which paper money is freely convertible into a fixed amount of gold. In other words, in such a monetary system, gold backs the value of money. Between 1696 and 1812, the development and formalization of the gold standard began as the introduction of paper money posed some problems.
The U.S. Constitution in 1789 gave Congress the sole right to coin money and the power to regulate its value. Creating a united national currency enabled the standardization of a monetary system that had up until then consisted of circulating foreign coin, mostly silver.
With silver in greater abundance relative to gold, a bimetallic standard was adopted in 1792. While the officially adopted silver-to-gold parity ratio of 15:1 accurately reflected the market ratio at the time, after 1793 the value of silver steadily declined, pushing gold out of circulation, according to Gresham's law.
The issue would not be remedied until the Coinage Act of 1834, and not without strong political animosity. Hard money enthusiasts advocated for a ratio that would return gold coins to circulation, not necessarily to push out silver, but to push out small-denomination paper notes issued by the then-hated Bank of the United States. A ratio of 16:1 that blatantly overvalued gold was established and reversed the situation, putting the U.S. On a de facto gold standard.
By 1821, England became the first country to officially adopt a gold standard. The century's dramatic increase in global trade and production brought large discoveries of gold, which helped the gold standard remain intact well into the next century. As all trade imbalances between nations were settled with gold, governments had strong incentive to stockpile gold for more difficult times. Those stockpiles still exist today.
The international gold standard emerged in 1871 following its adoption by Germany. By 1900, the majority of the developed nations were linked to the gold standard. Ironically, the U.S. Was one of the last countries to join. In fact, a strong silver lobby prevented gold from being the sole monetary standard within the U.S. Throughout the 19th century.
From 1871 to 1914, the gold standard was at its pinnacle. During this period, near-ideal political conditions existed in the world. Governments worked very well together to make the system work, but this all changed forever with the outbreak of the Great War in 1914.
The Fall of the Gold Standard
With World War I, political alliances changed, international indebtedness increased and government finances deteriorated. While the gold standard was not suspended, it was in limbo during the war, demonstrating its inability to hold through both good and bad times. This created a lack of confidence in the gold standard that only exacerbated economic difficulties. It became increasingly apparent that the world needed something more flexible on which to base its global economy.
At the same time, a desire to return to the idyllic years of the gold standard remained strong among nations. As the gold supply continued to fall behind the growth of the global economy, the British pound sterling and U.S. Dollar became the global reserve currencies. Smaller countries began holding more of these currencies instead of gold. The result was an accentuated consolidation of gold into the hands of a few large nations.
The stock market crash of 1929 was only one of the world's post-war difficulties. The pound and the French franc were horribly misaligned with other currencies; war debts and repatriations were still stifling Germany; commodity prices were collapsing; and banks were overextended. Many countries tried to protect their gold stock by raising interest rates to entice investors to keep their deposits intact rather than convert them into gold. These higher interest rates only made things worse for the global economy. In 1931, the gold standard in England was suspended, leaving only the U.S. And France with large gold reserves.
Then, in 1934, the U.S. Government revalued gold from $20.67/oz to $35/oz, raising the amount of paper money it took to buy one ounce to help improve its economy.9 As other nations could convert their existing gold holdings into more U.S dollars, a dramatic devaluation of the dollar instantly took place. This higher price for gold increased the conversion of gold into U.S. Dollars, effectively allowing the U.S. To corner the gold market. Gold production soared so that by 1939 there was enough in the world to replace all global currency in circulation.
As World War II was coming to an end, the leading Western powers met to develop the Bretton Woods Agreement, which would be the framework for the global currency markets until 1971. Within the Bretton Woods system, all national currencies were valued in relation to the U.S. Dollar, which became the dominant reserve currency. The dollar, in turn, was convertible to gold at the fixed rate of $35 per ounce. The global financial system continued to operate upon a gold standard, albeit in a more indirect manner.
References:
- Bhole, L.M. Financial Markets and Institutions. Tata McGraw-Hill Publishing Company.
- Pandian P. – Financial Service and Markets. Vikas Publishing House.
- Dhanekar. Pricing of Securities. New Delhi: Bharat Publishing House.
- Nibasaiya Sapna – Indian Financial System – S.Chand.
