Chapter 3 — Money And Credit

Money and credit are central to how modern economies work. The chapter begins by explaining why money developed — to overcome the limits of barter trade (double coincidence of wants, difficulty in storing value, measuring value, and divisibility). Money is anything widely accepted as a medium of exchange and a measure of value.

Key functions of money are described: medium of exchange, unit of account (measure of value), store of value, and standard of deferred payments. Important characteristics of good money include acceptability, durability, portability, divisibility, uniformity, recognisability, and limited supply.

Credit is the arrangement that allows people to obtain goods or services now and pay for them later. It helps households, businesses and governments to smooth consumption, purchase capital goods, and manage timing differences between incomes and expenditures. Credit can be provided by formal institutions (banks, cooperatives, NBFCs) and informal sources (moneylenders, relatives). Formal credit usually charges lower interest and requires documentation; informal credit is easier to obtain but often more expensive.

Banks play a special role: they accept deposits, provide loans, facilitate payments, and help create money in the economy through the lending process. Interest is the cost of borrowing and the reward for lending. The introduction also touches on the risks of credit (default, over-indebtedness) and the importance of safe borrowing, collateral, and reasonable interest rates.

Meaning of Money

Money is anything that is generally accepted as a means of payment for goods and services and in settlement of debts. It is a social institution that eliminates the inconveniences of barter by providing a common medium of exchange.

Essential Qualities of Money

• Acceptability: Widely accepted by people in exchange.
• Durability: Should not wear out quickly (e.g., metal coins, currency notes).
• Portability: Easy to carry for transactions.
• Divisibility: Can be divided into smaller units to buy inexpensive goods.
• Stability of value: Value should not fluctuate widely in short term.
• Recognizability: Easy to identify and hard to counterfeit.

Forms of Money

• Commodity money (e.g., gold, silver when they were used directly).
• Metallic money (coins).
• Paper money (currency notes issued by the government or central bank).
• Bank money (deposits, cheques, electronic bank balances).

Main Functions of Money

1. Medium of Exchange: Money is used to buy and sell goods and services, replacing barter. This removes the need for a coincidence of wants.
2. Unit of Account (Measure of Value): Prices of goods are expressed in monetary units, making comparison and accounting easier.
3. Store of Value (Wealth Preservation): Money can be saved and used in the future to buy goods and services (subject to inflation).
4. Standard of Deferred Payments: Money is used to settle debts and contracts that require payments in the future (loans, instalments).
5. Transfer of Value: Money allows value to be transferred across time and space (gifts, remittances).

Why these functions matter (brief link to economy): By acting as a medium of exchange and unit of account, money increases market efficiency and specialization. As a store of value and standard for deferred payments, it supports saving, lending and credit — which in turn enable investment, production and economic growth.

Introduction

Money is anything that is generally accepted as a medium of exchange, a store of value and a unit of account. Over time money has evolved from commodities to coins, paper notes and now digital forms. Understanding the main types and the essential characteristics helps explain how money functions in the economy.

Types of Money

• Commodity money: Money that has intrinsic value because the commodity itself is useful (e.g., gold, silver, cattle, salt). Historically people used these items directly in exchange.
• Metallic money: Coins made of precious or base metals (gold, silver, copper). Durability and recognizability made them popular.
• Representative money: Paper notes or certificates that represent a claim on a commodity (e.g., a gold certificate). They can be exchanged for a fixed amount of the commodity.
• Fiat (paper) money: Currency issued by the government and declared legal tender (e.g., Indian Rupee notes). It has value because the government and people accept it, not because of intrinsic commodity value.
• Bank money / Deposit money: Demand deposits in banks that can be used for payments via cheques, debit cards or transfers. Most modern transactions occur using bank money rather than cash.
• Credit money / Negotiable instruments: IOUs, promissory notes, bills of exchange and credit cards — promises to pay in the future that circulate as means of payment.
• Electronic / Digital money: Money stored and transferred electronically — e.g., mobile wallets, UPI balances, online bank transfers and cryptocurrencies (Bitcoin). They function as money when widely accepted.

Characteristics of Good Money

For any object to function effectively as money it should have:

1. Acceptability — People must accept it as a medium of exchange. (Example: legal tender status helps.)
2. Durability — It should withstand wear and tear (coins and well-made notes).
3. Portability — Easily carried and transferred (paper notes, cards, digital balances).
4. Divisibility — Must be divisible into smaller units to buy goods of different values (coins, paise/rupee subdivisions, paise to rupee; digital units can be divided further).
5. Uniformity (homogeneity) — Units of money should be identical in value (a one-rupee coin equals another one-rupee coin).
6. Limited supply / Scarcity — Supply must be controlled so it retains value; unlimited printing causes inflation.
7. Recognizability / Authenticity — Easy to identify and hard to counterfeit (security features on banknotes).
8. Stability of value — Value should be relatively stable over time so it can serve as a store of value.
9. Divisible and fungible — Interchangeable units and ability to combine or split for transactions.

Why these matter (brief)

If money lacks these characteristics, people will hesitate to accept it (loss of acceptability), causing transactions to return to barter or alternative means — harming economic activity. Modern monetary systems aim to maintain acceptability and stability through central bank policy and legal rules.

Short summary

Types of money reflect historical evolution from commodities to digital records. The core characteristics ensure that money can perform the three main functions: medium of exchange, store of value, and unit of account.

Meaning of Credit

Credit is an agreement in which a lender allows a borrower to obtain goods, services or money now and repay at a later date. It is essentially trust extended by the lender that the borrower will repay in future. In economics and banking, credit is the provision of funds by one party to another on the condition of future repayment with or without interest.

Key features of credit

• Deferred payment: The borrower receives benefit now and pays later.
• Interest: Lenders usually charge interest as the cost of providing credit.
• Trust and creditworthiness: Lenders assess the borrower’s ability and willingness to repay.
• Collateral/security: Some loans require assets as security against default.
• Formal and informal sources: Formal sources include banks and cooperatives; informal sources include moneylenders, relatives and traders.

Types and sources of credit

• Bank loans and advances (personal loans, home loans, business loans).
• Overdrafts and lines of credit.
• Trade credit (credit extended by sellers to buyers).
• Credit cards and consumer credit (EMIs, instalment purchases).
• Agricultural and microfinance credit for small borrowers.

Importance of credit

• Consumption smoothing: Credit lets households buy essential goods or durables (like appliances) when they lack immediate funds.
• Facilitates investment and business expansion: Firms borrow to buy machinery, hire workers, and expand production, increasing output and employment.
• Helps in emergencies: Loans cover medical expenses, sudden repairs or crop failure, preventing distress sales of assets.
• Supports education and human capital: Student loans enable investment in skills and future earnings.
• Promotes economic growth: Well-allocated credit increases aggregate demand and investment, spurring growth.
• Promotes trade: Trade credit between firms smooths transactions and supports supply chains.

Risks and limits of credit

• Over-indebtedness: Excess borrowing can lead to repayment difficulty, defaults and financial distress.
• Interest burden: High interest rates make credit expensive, reducing disposable income and profitability.
• Moral hazard and adverse selection: Borrowers may take higher risks after borrowing or risky borrowers may be those seeking loans.
• Dependence on informal lenders: High-cost informal credit can trap poor households in debt cycles.

Role of banks, financial institutions and policy

Banks evaluate creditworthiness, create credit by lending deposits, and channel savings into productive uses. Central banks and regulators (for example the RBI) set rules on lending, interest rates and reserve requirements to ensure stability and to influence the availability and cost of credit.

Practical points for borrowers

• Borrow only what you can repay; compare interest rates and terms.
• Understand EMIs, tenor, penalties and collateral requirements.
• Maintain good credit behaviour to access formal cheaper credit in future.

What is credit? Credit is the provision of funds or goods by one party to another with the expectation of future repayment, usually with interest. Credit helps households, farmers and businesses to meet short-term needs and invest for the long term.

Types of credit by duration

• Short-term credit (up to 1 year): Used for working capital and seasonal needs (e.g., a farmer's loan for seeds, fertiliser). Repayment is expected within a crop season or business cycle.
• Medium-term credit (1–5 years): Used to buy equipment, tractors, small machinery or for improving land. Repayment is spread over a few yearly instalments.
• Long-term credit (more than 5 years): Used for large investments such as buying land, building houses, factories; repaid over many years (e.g., home loans, industrial term loans).

Types of credit by source

• Formal/Institutional credit: Provided by scheduled banks, cooperative banks, Regional Rural Banks (RRBs), and other recognised financial institutions. Advantages: lower interest rates, regulated, documentation and protection. Examples: bank crop loans, home loans.
• Informal credit: Given by moneylenders, traders, relatives, landlords and local unscrupulous lenders. Often quick and flexible but carries high interest rates and unfavourable terms.

Other important distinctions

• Secured (collateral) vs Unsecured credit: Secured loans require collateral (mortgage, pledged assets). Unsecured loans (personal loans, many credit cards) do not require collateral and often have higher interest.
• Revolving vs Term credit: Revolving (e.g., credit card, overdraft) allows repeated borrowing up to a limit as long as repayments continue. Term loans (e.g., medium/long-term loans) are disbursed once and repaid in scheduled instalments.
• Purpose-based credit: Agricultural credit, industrial/enterprise credit, consumer credit (for goods), education loans, housing loans, etc.

Key features of credit: lenders check creditworthiness, purpose, collateral and repayment capacity. Credit carries interest (cost of borrowing), and conditions (tenure, instalments, penalties).

Why the type matters: Choosing the right type reduces cost and risk — e.g., formal short-term crop loans at lower rates protect farmers from exploitative informal moneylenders; long-term mortgage spreads repayment for affordability.

What is credit? Credit is the ability to obtain goods, services or money now and pay for them in the future. In an economy, credit helps households, farmers and businesses to meet consumption and investment needs.

Main classification of sources of credit

• Formal sources – These are regulated and institutional. They include commercial banks, cooperative banks and societies, regional rural banks (RRBs), microfinance institutions and non-banking financial companies (NBFCs). Formal lenders usually require documentation, have lower interest rates, and may ask for collateral or guarantors.
• Informal sources – These are unregulated and personal. They include moneylenders, traders, landlords, relatives and friends. Informal credit is easily accessible, often available quickly and without paperwork, but usually carries higher interest rates and less protection for borrowers.

Purpose and period of loans

• Short-term credit – for working capital or consumption (e.g., crop loans, business cash needs). Usually repayable within one year.
• Long-term credit – for investment in assets (e.g., buying machinery, house construction). Repayable over several years.

Key features to compare

• Interest rate: Formal lenders generally charge lower rates than informal lenders.
• Documentation & procedure: Formal loans require applications, KYC, and appraisal; informal loans need little or no paperwork.
• Security/collateral: Formal sources often ask for collateral; some formal schemes (e.g., Kisan Credit Card, microcredit groups) may offer collateral-free small loans. Informal lenders may rely on social pressure or physical collateral.
• Accessibility and speed: Informal credit is faster and more flexible but costlier.

Role in the economy

Accessible credit helps farmers buy seeds and fertilisers, businesses buy inputs and expand, and households cope with emergencies. Formal credit penetration reduces dependence on exploitative informal credit and supports stable economic growth.

How to obtain formal credit (typical steps)

• Submit application with identity and income proofs (KYC).
• Loan appraisal by lender (check purpose, repayment capacity).
• Sanctioning of loan and agreement on interest rate and tenure.
• Disbursement of funds and regular repayment (EMI/instalments).

Advantages and disadvantages (summary)

• Formal sources – Advantages: lower interest, regulated, legal protection. Disadvantages: paperwork, longer processing, collateral often required.
• Informal sources – Advantages: quick, flexible, small amounts and easy terms. Disadvantages: very high interest, risk of harassment, no consumer protection.

Overview
Banks and financial institutions act as intermediaries between savers and borrowers. They mobilise savings, provide loans, facilitate payments, help in credit creation and support economic activity by directing funds to productive uses.

Main roles

• Mobilising savings: Banks accept different types of deposits (savings, current, fixed), encouraging people to save safely and earn interest.
• Providing credit and loans: Banks and financial institutions give short-, medium- and long-term credit for consumption, business, agriculture, education, housing and industry.
• Financial intermediation: They channel idle funds of savers to those who want to invest or borrow, thus promoting investment and growth.
• Facilitating payments: Banks offer payment services—cheques, demand drafts, NEFT/RTGS/IMPS, cards, UPI and clearing—making trade and daily transactions easier and safer.
• Credit creation: By keeping a fraction of deposits as reserves, commercial banks lend the rest; these loans get redeposited and create more deposits and loans (money multiplier effect).
• Agency and utility services: Collection and payment of cheques, standing instructions, locker facilities, pension/disbursement services, forex and letters of credit.
• Risk management and investment products: Insurance companies, mutual funds and pension funds help households manage risks and invest in diversified portfolios.
• Support to government and economy: Central bank (e.g., RBI) issues currency, regulates banks, controls money supply, acts as banker to government and lender of last resort. Financial institutions support fiscal operations and developmental projects.

Types of institutions and their special roles

• Central bank (RBI): Issues currency, formulates monetary policy, regulates and supervises banks, maintains price stability and financial stability.
• Commercial banks: Accept deposits, provide advances, create credit and run payment systems (examples: SBI, HDFC).
• Co-operative banks and Regional Rural Banks (RRBs): Provide credit and banking services in rural and semi-urban areas, support agriculture and small borrowers.
• Non-Banking Financial Companies (NBFCs): Provide loans, hire-purchase and financial services where banks may not reach; e.g., microfinance institutions.
• Insurance companies and mutual funds: Mobilise long-term savings and provide risk cover and investment avenues (e.g., LIC, mutual fund houses).

Why their role matters
Efficient banks and financial institutions reduce the cost of borrowing, improve access to finance, support entrepreneurship, stabilise incomes (via insurance), and help implement monetary and fiscal policies—thereby aiding overall economic development.

Important safeguards and regulations
To ensure safety of deposits and financial stability, banks follow rules such as KYC (know your customer), maintain CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio), and operate under supervision by the central bank and other regulators.

What are Terms and Conditions of Credit?

Terms and conditions of credit are the rules and features a lender sets for giving a loan or credit. They determine how much is lent, how long it must be repaid, how it must be repaid, what security is required, and the cost of borrowing.

Main components

• Principal (Amount): The sum lent to the borrower.
• Rate of interest: The percentage charged on the principal (annual or monthly).
• Tenure / Period: Duration over which the amount must be repaid.
• Repayment method: Lump sum, instalments, EMI, bullet repayment or moratorium.
• Security / Collateral: Assets (house, gold) pledged for secured loans; unsecured loans have none.
• Purpose restriction: Some loans are for specific purposes (home, education, car).
• Processing fees and other charges: Administrative fees, prepayment penalty, late-payment charges.
• Documentation and eligibility: Income proof, identity, credit history, guarantor requirements.
• Consequences of default: Late fees, legal action, seizure of collateral, adverse credit record.

Secured vs Unsecured: Secured loans (home, car) usually have lower interest rates because of collateral. Unsecured loans (personal loans, informal credit) usually charge higher rates and may have stricter short-term terms.

Why these terms matter: They determine the affordability and risk for the borrower and the safety and return for the lender. Careful comparison of terms helps borrowers choose cheaper and safer credit.

Overview

Credit allows people and businesses to borrow money today and repay later. While credit supports consumption, production and growth, it also creates problems when borrowed money cannot be repaid or when borrowing is expensive or unfair. The main problems associated with credit are over‑indebtedness, high interest burdens, exploitation by informal lenders, asset loss, and misuse of loans.

Key problems (concise explanation)

• Over‑indebtedness: Borrowers (farmers, small traders, households) take multiple loans or large loans relative to their income. If income is low or irregular, repayments become unmanageable, creating a cycle of borrowing to repay earlier loans.
• High interest and compounding: Informal lenders often charge very high rates. Interest that is simple or compounded increases total repayment a lot and can quickly exceed the borrower’s ability to pay.
• Exploitative conditions and lack of transparency: Informal lending may include hidden charges, forced collateral surrender, or unfair terms. Borrowers often lack information about actual cost of credit.
• Loss of assets and forced sales: If loans are secured by land, livestock or jewellery, failure to repay can lead to loss of essential assets, reducing future income and increasing poverty.
• Diversion and misuse of credit: Loans intended for productive purposes (e.g., agriculture) may get used for consumption or social needs, lowering chances of generating income to repay.
• Vulnerability to shocks: Crop failure, illness or job loss can reduce income suddenly; without savings or insurance, borrowers cannot meet repayments.
• Social consequences: Prolonged indebtedness causes stress, family disruption, reduced investment in education/health and in extreme cases has led to desperate actions by borrowers.

Why the problems occur

• Limited access to formal credit (banks) — high documentation, collateral requirements and transaction costs push people to informal lenders.
• Information asymmetry — lenders or middlemen may have more information and leverage; borrowers lack awareness of rights and alternatives.
• Irregular incomes — seasonal farmers, casual workers have income timing problems making fixed repayments difficult.
• No risk‑sharing instruments — lack of crop or health insurance forces people to rely on credit to cope with shocks.

Mitigation measures (brief)

• Expand access to formal credit: simplified accounts, small loans, self‑help groups (SHGs).
• Financial literacy: teach borrowers to compare rates, read terms, avoid unnecessary multiple loans.
• Regulation: cap usurious rates, enforce transparency, monitor moneylenders.
• Social protection: crop insurance, unemployment support, savings programs to reduce emergency borrowing.

Understanding how interest works and how repayments are scheduled helps explain why small differences in interest rates and compounding lead to large differences in repayment obligations — and why unchecked credit can become a serious social and economic problem.

What is access to credit? Access to credit means that households, farmers, small businesses and entrepreneurs can obtain timely loans and other financial services from formal sources (banks, cooperatives, microfinance institutions) at reasonable cost. Improved access helps investment, smooth consumption, start/expand businesses and reduce dependence on informal high-cost lenders.

Why measures are needed: Large sections—especially in rural areas and among small borrowers—face difficulty getting formal loans because of lack of collateral, distance from banks, paperwork, low financial literacy and high transaction costs. Measures to improve access reduce poverty and support growth.

• Expand branch and delivery networks: Open more bank branches, regional rural banks (RRBs) and rural bank outlets. Use Business Correspondents (BCs) and agent networks to reach remote villages.
• Promote group lending and SHGs: Self‑Help Groups (SHGs) and joint liability groups reduce risk for lenders and allow collateral‑free lending. SHG–bank linkage programs help small savers and borrowers access formal credit.
• Targeted government schemes: Credit schemes such as Kisan Credit Card (for farmers), MUDRA loans (for micro enterprises) and other priority sector lending policies guide banks to lend to underserved sectors.
• Collateral‑free and credit guarantee schemes: Credit Guarantee Funds (e.g., for small enterprises) reduce the need for collateral by assuring banks against defaults, encouraging lending to first‑time and small borrowers.
• Simplify procedures and reduce documentation: Streamlined loan application forms, standardized KYC, and quicker sanction processes lower barriers for small borrowers.
• Use technology and digital finance: Mobile banking, e‑KYC, online loan applications, digital payments and direct benefit transfers (JAM: Jan Dhan–Aadhaar–Mobile) bring services closer, reduce costs and speed up credit delivery.
• Strengthen cooperative banks and microfinance institutions: Support and regulate cooperative credit institutions and microfinance to provide stable rural finance.
• Improve credit information and alternative scoring: Credit bureaus, Aadhaar‑linked records, and alternative data (e.g., mobile payments, utility bills) help assess creditworthiness of borrowers without formal records.
• Financial literacy and counselling: Educating borrowers about interest rates, repayment schedules, budgeting and formal loan options reduces defaults and builds credit history.
• Promote competition and reasonable regulation: Encouraging more lenders (banks, NBFCs, fintechs) while protecting consumers through fair interest rate disclosure reduces costs and expands choices.

Outcome: When these measures are combined—physical outreach, targeted schemes, technology, simplified rules and credit guarantees—they increase the supply of formal credit, lower borrowing costs, and reduce reliance on informal moneylenders.

Overview
This topic covers the core ideas you need to understand how money and credit work in an economy: what money is, its functions and types, what credit means, who supplies and borrows credit, how banks create credit, and the role of interest, collateral and formal/informal sources.

Money — definition and characteristics
Money is any widely accepted medium of exchange used to buy goods and services and to settle debts. Key characteristics: acceptability, durability, divisibility, portability, recognisability and stability of value.

Functions of money

• Medium of exchange — facilitates buying and selling without barter.
• Unit of account — prices and accounts are quoted in money terms.
• Store of value — wealth can be held and used later.
• Standard of deferred payment — used to settle credit transactions in future.

Types of money
Commodity money (e.g., gold, salt), fiat money (currency issued by the government), bank (deposit) money created by banking operations, and electronic/digital money (cards, UPI, e-wallets).

Credit — definition and features
Credit is the provision of funds by a lender to a borrower with the agreement that the borrower will repay at a later date, usually with interest. Features include time element (deferred payment), interest, and sometimes collateral or guarantee.

Interest and collateral
Interest is the price paid for borrowing funds (expressed as a percentage rate). Collateral is an asset pledged by the borrower to secure a loan; it reduces lender risk.

Formal and informal sources of credit

• Formal sources: commercial banks, cooperative banks, regional rural banks, microfinance institutions linked to the formal sector. They charge regulated interest and require documentation/collateral.
• Informal sources: moneylenders, traders, relatives and friends. Easier access but often higher interest and less regulation.

Credit instruments and services
Common instruments: cash loans, overdrafts, fixed-term loans, demand drafts, cheques, promissory notes, credit cards. Services include loan appraisal, disbursement, monitoring and recovery.

Credit creation by banks (concept)
When banks accept deposits, they keep a part as required reserves and lend out the rest. Loans become deposits in other banks, enabling further lending. This process multiplies the initial deposit and increases the money supply — called credit (or money) creation.

Demand and supply of credit
Demand for credit comes from households (homes, education), firms (investment), and farmers (agri inputs). Supply of credit comes from banks, financial institutions and informal lenders. Interest rate acts as the ‘price’ balancing demand and supply.

Why credit matters and policy role
Credit enables consumption smoothing, investment and economic growth. The central bank (RBI) and government regulate credit through policy rates, reserve requirements and directed credit programs to ensure adequate and affordable credit, especially for priority sectors (agriculture, SMEs).