What are the Merits and Demerits of Proportional Reserves System?

Under the proportional reserve system, certain proportion of currency notes (40%) are backed by gold and silver reserves and the remaining part of the note issue by approved securities.

India adopted this method on the recommendation of Wilton Young Commission. According to the Reserve Bank of India Act 1933, not less than 40 per cent of the total assets of the Issue Department should consist of gold bullion, gold coins and foreign securities, with the additional provision that gold coins and gold bullion were not at any time to be less than Rs. 40 crores.

The proportional reserve system was later replaced by the minimum reserve system by the Reserve Bank of India (Amendment) Act, 1956.

Merits

The proportional reserve system has the following advantages:

(i) It guarantees convertibility of paper currency.

(ii) It ensures elasticity in the monetary system; the monetary authority can issue paper currency much more than that warranted by reserves.

(iii) It is economical and can be easily adopted by the poor countries.

Demerits

The proportional reserves system suffers from the following defects.

(i) Under this system, it is easy to expand currency but very difficult to reduce it. The reduction of currency has deflationary effects in the economy.

(ii) There is wastage of gold because large amount of gold lies in the reserve and cannot be put to productive use.

(iii) The convertibility of paper notes is not real. In practice, high denomination notes are converted into low denomination notes and not into coins.