Proportional Reserve System of Note Issue Explained

Proportional Reserve System

First let's understand the meaning of three words, namely:

1. Proportion means a part, percentage or share of something regarded as a collective whole.
2. Reserve implies something valuable stocked up systematically or stored carefully often on a large scale at a secured location.
3. A System comprises a set of detailed procedures, routines, and methods that are supposed to be followed to perform certain activities.

In Proportional Reserve System (PRS), certain proportion or percentage of the reserves has to maintained in the form of precious metals like Gold. The remaining part of the reserves is to be kept in specific assets such as Government Securities and Commercial Bills. Such a balance is maintained to give backing (support) to the total volume of currency notes issued by the apex central bank of a nation like FED in the USA, RBI in India, etc.^[1]

For example, the Federal Reserve Act (1913) prescribed the Federal Reserve System (FED) of the USA to back currency notes issued by 40% Gold and remaining 60% by Government Securities.^[2]

The proportion of precious metals in the reserves usually varies from 25% (e.g. Canada and Argentina) to 40% (e.g. Germany, USA, and India). The remaining proportion of the reserves must consist of approved securities that change from 75% (e.g. Canada and Argentina) to 60% (e.g. Germany, USA, and India). In other words, if Gold makes 25% of the reserves then Securities will make its 75%. Similarly, if Gold is about 40% of the reserves, then Securities will occupy its 60% and so on.^{[1] [3] [4]}

The nation of Germany was first to adopt the Proportional Reserve System of note issue in the year 1875.^{[3] [6]}

The Proportional Reserve System of note issue gained popularity after First World War.^[1]

PRS was adopted by the USA (at 40% Gold) in 1914, France (at 30% Gold) in 1928 and later by many other countries of the world.^[3]

On recommendations of Hilton Young Commission, PRS was adopted by India (at 40% Gold) in 1927.^[1]

India followed Proportional Reserve System of note issue between 1935 and 1956.^[6]

The original RBI Act of 1934 had a provision that mentioned the issuance of currency notes must be according to the Proportional Reserve System.^[5]

The original act required RBI to maintain 40% of reserves in Gold for backing the issue of currency notes in India.^[7]

On 6^th October 1956, RBI replaced PRS with another method of note issue called ‘Minimum Reserve System.’ This step was taken to enable and fulfill the expanding currency needs of the Indian economy.^[7]

Main limitations or disadvantages of Proportional Reserve System:^[1]

1. Precious metals remained locked in vaults of reserves, and their productive use hindered. It was a waste of valuable metallic resources.
2. Though it was easy to expand (increase) the money supply, it was difficult to contract (decrease) supply of paper notes in case the reserves fell.

Following seven references were studied to compile this article:

1. ^ T. R. Jain and O. P. Khanna. Indian Financial System, Semester III, 1^st Edition. Chapter No.9. Page No.131. ISBN 978-93-80901-62-6.
2. ^ Clifford Gomez. Financial Markets, Institutions, and Financial Services, 2008 Edition. Chapter No.22. Page No.215. ISBN 978-81-203-3537-0.
3. ^ Kumar B. Das and Sarojini Das. Exposition To Economics, 1^st Edition. Chapter No.15. Page No.308. ISBN 81-7099-236-2.
4. ^ M. C. Vaish. Monetary Theory, 16^th Edition. Chapter No.9. Page No.112. ISBN 9788125918455.
5. ^ Mishra and Puri. Indian Economy, 29^th Edition. Chapter No.47. Page No.604. ISBN 9789350510742.
6. ^ E. Narayanan Nadar. Money and Banking, 2013 Edition. Chapter No.2. Page No.38 and 41. ISBN 978-81-203-4795-3.
7. ^ "Brief History of RBI - Chronology of Events - 1950 to 1960". Retrieved 10 October 2015.