The relationship between note issue and its reserve backing is usually done on the basis of a reserve system by central banks across the world. The reserve system provides guidelines for the issue of new currencies.
In India, currencies are issued by the RBI with the backing of reserves comprised of gold and foreign exchange (foreign currencies). For the issue of currencies, the RBI follows Minimum Reserve System at present. The Minimum Reserve System (MRS) is followed from 1956 onwards.
Under the Minimum Reserve System, the RBI has to keep a minimum reserve of Rs 200 crore comprising of gold coin and gold bullion and foreign currencies. Out of the total Rs 200 crores, Rs115 crore should be in the form of gold coins or gold bullion. The purpose of shifting to MRS was to expand money supply to meet the needs of increasing transactions in the economy.
The minimum reserve is a token of confidence and doesn’t have any practical connection with amount new currencies issued by the RBI. Under the Minimum Reserve System, RBI can issue unlimited amount of currency by keeping the reserve. But RBI follows some principle or rule for issuing new currencies based upon economic growth and transaction needs of the people.
How RBI issues new currencies?
For every year, RBI makes a money supply expansion target based on the expected economic growth. Higher the economic growth, higher will be the expansion of newly issued money by the RBI. This strategy helps RBI to contain inflation as well as enabling people to meet their transaction needs.
Similarly, the RBI secures assets while issuing new currency into the economy. These assets are foreign currencies or government bonds. Every unit of new currency is a liability of the RBI. To match this liability, there should be equal volume of assets as well. The procured foreign currency and government bonds constitute to the assets of the RBI whereas the newly issued currency is its liability. Foreign currencies purchased by the RBI are kept at Banking Department whereas the resaves used for issuing new currency (under MRS) is kept at Issue Department.