In order to issue currency notes of different denominations, the RBI followed a system as the backing of the value of notes issued, which is known as proportional reserve system. The proportional reserve system of note issue was followed in India until 1956. The current system used for note issue is minimum reserve system.
Reserve bank of India maintains certain reserves. This is to provide support to the total volume of currency issued by the Reserve Bank of India. According to proportional reserve system, out of the reserves, certain percentage or proportion has to be held in the form of precious metals like gold. The remaining amount of reserves is to be maintained in the form of assets such as commercial bills or government securities. Proportional reserve system was adopted in India on recommendations of Hilton Young Commission in 1927.
- This system guarantees convertibility of paper currency.
- The monetary authority can issue paper currency much more than that warranted by reserves thereby it ensures elasticity in the monetary system;
- This method of note issue is economical and can be easily adopted by the developing or under-developed countries.
- Under this system, a large amount of precious metal lies locked in the reserve and cannot be put to productive use. This results in wastage of their use.
- It is easy to expand or increase the currency but very difficult to reduce it. The reduction of currency has deflationary effects in the economy.
- In practice, high denomination notes are converted into low denomination notes and not into coins. Therefore the convertibility of paper notes is not practical.