Principles of note issue
There are two principles of note issue, one is called the Currency Principle and the other is named as Banking Principle. Both these principles are contradictory to each other.
(1) Currency Principle. According to the currency principle, the central bank of the country should keep 100% gold for every note issued In other words their should be full convertibility for the amount of legal tender currency It assumes full convertibility of notes.
The advocates of this principle of note issue are of the view that the currency under this system will expand or contract as it would have expanded or contracted under the metallic money. The currency principle assures maximum safety for the notes. Those who oppose this principle assert that the system no doubt gives safety to the currency but it lacks elasticity. The supply of notes is tied down to the supply gold available in the country. This system also fails to take into consideration the commercial banks power to create credit.
(2) Banking Principle. According to this principle, there is no need to keep 100% gold or silver against notes issued. The notes issued should have a guarantee of convertibility into gold. It is sufficient to keep only a certain percentage of total paper currency in the form gold and silver reserves. The notes issued in the country should be according to the needs of trade and 4ndustry. It at any time there is an excess of notes issued to the requirements of trade and industry, these will be returned to the bank of issue for conversion.
The principle of note issue has the merit that it provides the country with an elastic currency. The guarantee of convertibility also acts as a regulator of note issue. Since it does not require 100% metallic backing against the note issue, it is therefore most economical principle. The demerit of this principle is the danger of over issue of notes, possibility of inconvertibility of excess notes, loss of public confidence in the currency and monetary instability.