Earlier today, Grandia's inventory system really ruined a game session for me. Grandia uses a limited inventory system, where each character in the party can only carry twelve items, not counting equipped weapons and armor, with no team reserve. I was exploring a section of what could be the final dungeon when I found a Spirit Helm: most likely the strongest helmet in the game. Unfortunately, all of my characters had full inventories, so I was asked what to do with the Helm I just picked up. In a tragic turn of events, I accidentally chose the "Discard Found Item" option instead of the "Discard Item in Inventory" option, and permanently lost out on one of the most powerful pieces of equipment in the game. Needless to say, I had no choice but to turn off my PS2 without saving, and now I am facing the prospect of not only retracing my steps up to that point, but trekking all of the way out of the dungeon just to drop some of the junk in my inventory into storage. This entire incident is a perfect example of some of the flaws in character limited inventory systems.
There is plenty of good reason in limiting the number of items a player has access to in an RPG. In a typical RPG, such as in most Final Fantasy games, every player-controlled character has access to a massive inventory with a potentially nigh-limitless number of healing items and possibly even attack items. With an inventory full of sufficiently powerful healing items, it becomes easy for a player to keep his characters healed during a long battle. So, limiting the player's usable inventory is a valid means of adjusting the difficulty of a game.
Unfortunately, limiting inventory space has a lot of other effects on gameplay. Most RPGs typically hand out a lot of treasure in dungeons: be it more potions, new and improved equipment, or items destined to be sold at the next shop. In a game where the player only has ready access to a limited inventory, the player has to budget a large part of his inventory space to store those items, or else start throwing old items away in order to make room. Thankfully, most games with limited inventory have some means of storing unneeded items, but such games rarely let the player send things into that storage space from inside the dungeon, causing the player to still have to make tough decisions about what to keep and what to throw away. I remember having to throw away a lot of unidentified weapons and armor in Breath of Fire: Dragon Quarter because of that games' limited inventory. Having to throw items away like that is frustrating, since it feels so wasteful.
A particular problem of Grandia's system is that characters keep all of their items when they leave the party temporarily. So, I have been put in situations where one character leaves for a dungeon, and takes the main character's only axe with him, limiting my weapon choices. This particular problem could have been avoided if the player was given the chance to redistribute items between characters when someone leaves the party, or at the very least the character's items were dumped into storage (as is the case for characters who leave permanently).
Another effect of limited inventories is that it usually limits what items the player will actually use to just the bare essentials. Grandia's shops are full of various non-healing battle items, such as bombs that are effective on certain types of enemies, items that boost various stats, and items that drop various enemy stats. Unfortunately, I never could justify bringing those items with me into a dungeon. I could only ever afford to bring four or five items per character into a new area; any more and I risked having to start throwing stuff away. Since that included one or two spare weapons per character, I had to prioritize bringing the most essential items: revival potion and only my most powerful all-character HP and MP restoration items. I simply had no room to bring anything else, which left 70% of the items in the game a waste of inventory space. It is a real shame.
My favorite inventory system of all time has to be Kingdom Hearts' hybrid inventory system. In Kingdom Hearts, each character keeps their own inventory of items, and each character is differentiated by the maximum number of items they can carry. At the same time, there is a shared party inventory that can carry the typical large number of items, with the exception that it can't be accessed during battle. In addition, items in a character's inventory can be set to be automatically restocked from the party inventory after a battle, which helps cut down on the number of minor tasks the player has to worry about. So all told, the Kingdom Hearts inventory system has the advantage of limiting the player's inventory for balance purposes, but at the same time it helps distinguish different characters' strengths, limits needless hassle, and prevents the problem of having to worry about throwing stuff away to make room for new items. If a game designer wants to implement a limited inventory system, that is the example I would recommend looking at.