Grade is an assessment of the kind of work a student has done. Teachers usually judge students on the basis of their grades. A good student certainly has better grades than a bad student. Students also judge their capability on the basis of the grades they are given. Better grades indicate better work. I completely agree that grades do encourage the students to learn and work more.
Grades develop a competitive spirit among students. When I see my friends getting better grades in a subject, even I am compelled to work more and get good grades. It's human nature to want everything that others have. Better grades show the interest a student has in a particular subject. Zeal to work more creeps in. Sincerity towards work increases and self confidence boosts up.
Generally, students with good grades attract attention. Other students seek their advice and take help from their notes. Once a student gets a better grade, he strives to give his best. Parents feel proud of their children and encourage them to work more. Students realise the importance of hard work in life. They try to excel in everything they do. Also, to pursue a career of their own choice a student needs good grades in the lower classes and this encourages him/her.
Certain demerits of the grade system are that it segregates the students based on their grades. Students with good grades don't mingle with the ones with low grades. Students are discouraged when they work hard and end up with a low grade. This is discouraging and lowers the morale of the student and their enthusiasm fades away.
The merits of the grading system out way its demerits and hence it is relevant to say that grades encourage students to learn more.