Overview
Money and Credit begins with a question so ordinary that it is easy to miss: why does everyone accept money in exchange for what they have produced? The answer is that money removes the need for a double coincidence of wants, the crippling requirement of a barter system that each party must want exactly what the other is offering. Because money acts as a medium of exchange, an exchange can be separated into two parts, a sale and a purchase. The chapter then traces the modern forms of money - currency, which is authorised by the Reserve Bank of India on behalf of the central government and which no individual may refuse, and bank deposits, which are money precisely because they can be withdrawn on demand and transferred to another person by cheque. From deposits it moves to what banks do with them: keeping only a small proportion as cash and lending the rest, so that banks mediate between depositors with surplus funds and borrowers who need them. The second half of the chapter is about credit, and it insists that credit is neither good nor bad in itself. Two cases are set against each other - Salim, whose loan finances a profitable order and is repaid comfortably, and Swapna, whose crop fails and who is pushed into a debt trap - and the difference between them lies in the risk of the activity and the terms of credit. The chapter then divides lenders into a formal sector supervised by the RBI and an informal sector of moneylenders, traders and employers that charges much higher interest and answers to nobody, shows that the poor depend disproportionately on the informal sector, and ends with self-help groups as a way of bringing collateral-free credit to rural women.
Learning Objectives
- Explain why money is necessary, using the idea of double coincidence of wants.
- Describe the barter system and its limitations.
- Explain the two modern forms of money and why currency is accepted as a medium of exchange.
- Explain what demand deposits are and why they are counted as money.
- Explain how a cheque works and why deposits can be transferred without cash.
- Describe the loan activities of banks and explain how banks mediate between depositors and borrowers.
- Compare two contrasting credit situations and explain what makes credit useful or harmful.
- Define the terms of credit and explain the role of collateral.
- Distinguish formal from informal sources of credit and state the role of the Reserve Bank of India.
- Explain why the poor depend on informal credit and what the consequences are.
- Explain how self-help groups work and how they help the rural poor.
Topics in this chapter
8 topics · tap a topic title to jump straight to it.
Money as a Medium of Exchange
The question
Money is something that we use every day. But why does everyone accept money as a medium of exchange? Consider that we exchange money for goods or services whenever we buy something. Money acts as an intermediate in the exchange process, and it is therefore called a medium of exchange.
Double coincidence of wants
Before the introduction of money, exchanges were made through the barter system, where goods were directly exchanged without the use of money. In such a system, a person holding money can easily exchange it for any commodity or service that he or she might want. Thus everyone prefers to receive payments in money and then exchange the money for things that they want.
Consider a shoe manufacturer who wants to sell shoes in the market and buy wheat. In a barter system, he would have to look for a wheat-growing farmer who not only wants to sell wheat but also wants to buy the shoes in exchange. Both parties have to agree to sell and buy each other's commodities. This is known as double coincidence of wants.
What a person desires to sell is exactly what the other wishes to buy. This is an essential feature of the barter system, but such a coincidence is hard to find.
How money solves it
In an economy where money is in use, money by providing the crucial intermediate step eliminates the need for double coincidence of wants. It is no longer necessary for the shoe manufacturer to look for a farmer who will buy his shoes and at the same time sell him wheat.
All he has to do is find a buyer for his shoes. Once he has exchanged his shoes for money, he can purchase wheat or any other commodity in the market. Since money acts as an intermediate in the exchange process, it is called a medium of exchange. The exchange has been split into two independent halves: a sale and a purchase.
- Barter: goods exchanged directly for goods, with no money involved.
- Double coincidence of wants: what one person wants to sell is exactly what the other wants to buy - hard to find.
- Money splits one difficult exchange into two easy ones: sell shoes for money, then buy wheat with money.
Modern Forms of Money: Currency
What has served as money
Before the introduction of coins, a variety of objects was used as money. For instance, since the very early ages, Indians used grains and cattle as money. Thereafter came the use of metallic coins - gold, silver, copper coins - a phase which continued well into the last century.
Currency today
Modern forms of money include currency - paper notes and coins. Unlike the things that were used as money earlier, modern currency is not made of precious metal such as gold, silver and copper. And unlike grain and cattle, they are of no use of their own.
Why it is accepted then
Then why do people accept it as a medium of exchange? Currency is accepted as a medium of exchange because the currency is authorised by the government of the country.
In India, the Reserve Bank of India issues currency notes on behalf of the central government. As per Indian law, no other individual or organisation is allowed to issue currency. Moreover, the law legalises the use of rupee as a medium of payment that cannot be refused in settling transactions in India. No individual in India can legally refuse a payment made in rupees. Hence, the rupee is widely accepted as a medium of exchange.
- Grains and cattle served as money in early India; then metallic coins of gold, silver and copper.
- Modern currency has no use of its own and is not made of precious metal.
- It works because the RBI issues it on behalf of the central government and the law makes it impossible to refuse a payment in rupees.
Modern Forms of Money: Deposits with Banks
The second form
The other form in which people hold money is as deposits with banks. At a point of time, people need only some currency for their day-to-day needs. For instance, workers who receive their salaries at the end of each month have extra cash at the beginning of the month. What do people do with this extra cash? They deposit it with the banks by opening a bank account in their name.
Banks accept the deposits and also pay an interest rate on the deposits. In this way people's money is safe with the banks and it earns an amount as interest.
Why they are called demand deposits
People also have the provision to withdraw the money as and when they require. Since the deposits in the bank accounts can be withdrawn on demand, these deposits are called demand deposits.
The cheque
Demand deposits offer another interesting facility. It is this facility which lends it the essential characteristics of money. You would have heard of the payment being made by cheque instead of cash.
For payment through cheque, the payer who has an account with the bank makes out a cheque for a specific amount. A cheque is a paper instructing the bank to pay a specific amount from the person's account to the person in whose name the cheque has been issued.
The conclusion
The facility of cheques against demand deposits makes it possible to directly settle payments without the use of cash. Since demand deposits are accepted widely as a means of payment, along with currency, they constitute money in the modern economy.
- Deposits are safe and earn interest, and can be withdrawn on demand - hence the name demand deposits.
- A cheque is a paper instructing the bank to pay a specific amount from the payer's account to the named person.
- Because they are widely accepted as a means of payment, demand deposits are money along with currency.
Loan Activities of Banks
What banks do with the deposits
Banks keep only a small proportion of their deposits as cash with themselves. This is kept as provision to pay the depositors who might come to withdraw money from the bank on any given day. Since, on any particular day, only some of its many depositors come to withdraw cash, the bank is able to manage with this cash.
Banks use the major portion of the deposits to extend loans. There is a huge demand for loans for various economic activities.
How the bank earns
Banks make use of the deposits to meet the loan requirements of the people. In this way banks mediate between those who have surplus funds (the depositors) and those who are in need of these funds (the borrowers).
Banks charge a higher interest rate on loans than what they offer on deposits. The difference between what is charged from borrowers and what is paid to depositors is their main source of income.
Why this matters for the economy
Notice what this arrangement achieves. Money that would otherwise sit idle in thousands of households is gathered together and put to work financing crops, workshops, houses and businesses. The bank's real service is not storage but mediation.
- Banks keep only a small proportion of deposits as cash, because only some depositors withdraw on any given day.
- Banks mediate between depositors with surplus funds and borrowers who need them.
- The bank's main income is the gap between the interest it charges borrowers and the interest it pays depositors.
- \[Bank's main income = interest charged on loans - interest paid on deposits\]
Two Different Credit Situations
What credit is
Credit (loan) refers to an agreement in which the lender supplies the borrower with money, goods or services in return for the promise of future payment.
Salim: credit that helps
Salim obtains a loan from a trader to complete a large order for shoes on time. He has to supply 3,000 pairs within a month, and to complete production he has to hire more workers and buy raw materials. He obtains funds in two ways: he gets leather from a supplier on credit, to be paid three months later; and he asks the merchant who has placed the order for an advance payment of a part of the price.
At the end of the month Salim is able to deliver the order, make a good profit, and repay the money that he had borrowed. In this case credit plays a vital and positive role. It helps him to meet the ongoing expenses of production, complete production on time, and thereby increase his earnings. Credit therefore plays a crucial role in the country's development.
Swapna: credit that traps
Swapna, a small farmer, grows groundnut on her three acres of land. She takes a loan from the moneylender to meet the expenses of cultivation, hoping that her harvest would help repay the loan. However, this year the crop is hit by pests and the yield is low. Even though Swapna sprays her crops several times with expensive pesticides, it makes little difference.
The failure of the crop means that Swapna cannot repay the moneylender. Over the year the loan amount increases sharply due to interest. Next year Swapna takes a fresh loan for cultivation. It is a normal crop this year, but the earnings are not enough to cover the old loan. She is caught in debt and has to sell a part of the land to pay off the debt.
Swapna is now in a situation of debt-trap. Credit in this case pushes the borrower into a situation from which recovery is very painful.
The lesson
In one situation credit helps to increase earnings and the person is better off than before. In another, the borrower is left worse off. Whether credit would be useful or not depends on the risks in the situation and whether there is some support in case of loss.
- Salim's credit finances working capital for a profitable order and is repaid from the profit.
- Swapna's crop fails, her loan compounds, and a second loan cannot clear the first - the debt trap.
- The difference is not credit itself but the risk in the activity and whether any support exists in case of loss.
Terms of Credit and Collateral
What every loan agreement specifies
Every loan agreement specifies an interest rate which the borrower must pay to the lender along with the repayment of the principal. In addition, lenders may demand collateral (security) against loans.
Collateral
Collateral is an asset that the borrower owns (such as land, building, vehicle, livestocks, deposits with banks) and uses this as a guarantee to a lender until the loan is repaid.
If the borrower fails to repay the loan, the lender has the right to sell the asset or collateral to obtain payment. Property such as land titles, deposits with banks, livestock are some common examples of collateral used for borrowing.
The full definition
Interest rate, collateral and documentation requirement, and the mode of repayment together comprise what is called the terms of credit.
The terms of credit vary substantially from one credit arrangement to another. They may vary depending on the nature of the lender and the borrower.
Why collateral is the crucial term for the poor
Read the definition of collateral again and the whole problem of rural credit becomes visible. Collateral is an asset. Those who have no assets cannot offer collateral. Those who cannot offer collateral cannot borrow from banks. So the very people who most need cheap credit are pushed towards the lenders who do not ask for collateral — and who charge far more.
- Terms of credit = interest rate + collateral and documentation requirements + mode of repayment.
- Collateral: land, building, vehicle, livestock or bank deposits pledged as a guarantee until the loan is repaid.
- If the borrower fails to repay, the lender may sell the collateral to recover the money.
Formal and Informal Sources of Credit
The two sources
There are two types of loans available. Formal sector loans include loans from banks and cooperatives. Informal lenders include moneylenders, traders, employers, relatives and friends, etc.
Supervision
The Reserve Bank of India supervises the functioning of formal sources of loans. For instance, we have seen that the banks maintain a minimum cash balance out of the deposits they receive. The RBI monitors that the banks actually maintain the cash balance. Also, the RBI sees that the banks give loans not just to profit-making businesses and traders but also to small cultivators, small scale industries, to small borrowers etc.
Periodically, banks have to submit information to the RBI on how much they are lending, to whom, at what interest rate, etc.
No one supervises the informal sector
In contrast, there is no organisation which supervises the credit activities of lenders in the informal sector. They can lend at whatever interest rate they choose. There is no one to stop them from using unfair means to get their money back.
Why the cost matters so much
Compared to the formal lenders, most of the informal lenders charge a much higher interest on loans. Thus, the cost to the borrower of informal loans is much higher.
Higher cost of borrowing means a larger part of the earnings of the borrowers is used to repay the loan. Hence, borrowers have less income left for themselves. In certain cases, the high interest rate for borrowing can mean that the amount to be repaid is greater than the income of the borrower. This could lead to increasing debt and debt trap. Also, people who might wish to start an enterprise by borrowing may not do so because of the high cost of borrowing.
Who borrows from where
The rich households take credit mainly from formal sources, while the poor households depend mainly on informal sources. Thus, it is necessary that banks and cooperatives increase their lending particularly in the rural areas, so that the dependence on informal sources of credit reduces. It is also necessary that the benefits of formal credit reach the poor more than they do now.
- Formal: banks and cooperatives, supervised by the RBI. Informal: moneylenders, traders, employers, relatives and friends, supervised by nobody.
- The RBI checks the cash balance, sees that loans reach small cultivators and small borrowers, and requires periodic reporting.
- The rich borrow mainly from formal sources; the poor depend mainly on informal ones and pay far more.
Self-Help Groups for the Poor
The problem to be solved
The main reason why the banks are not willing to lend to the poor is the absence of collateral. Poor households continue to depend on informal sources.
How an SHG works
In recent years, people have tried out a new way of providing loans to the poor. The idea is to organise rural poor, in particular women, into small Self Help Groups (SHGs) and pool (collect) their savings.
- A typical SHG has 15-20 members, usually belonging to one neighbourhood, who meet and save regularly.
- Saving per member varies from Rs 25 to Rs 100 or more, depending on the ability of the people to save.
- Members can take small loans from the group itself to meet their needs. The group charges interest on these loans but this is still less than what the moneylender charges.
- After a year or two, if the group is regular in savings, it becomes eligible for availing loan from the bank. Loan is sanctioned in the name of the group and is meant to create self-employment opportunities for the members.
Why this works where banks alone do not
Most of the important decisions regarding the savings and loan activities are taken by the group members. The group decides as regards the loans to be granted — the purpose, amount, interest to be charged, repayment schedule etc. Also, it is the group which is responsible for the repayment of the loan. Any case of non-repayment of loan by any one member is followed up seriously by other members in the group.
Because of this group responsibility, banks are willing to lend to the poor women when organised in SHGs, even though they have no collateral as such. The group's own knowledge of its members replaces the security a bank would otherwise demand.
The wider effect
Thus, SHGs help borrowers overcome the problem of lack of collateral. They can get timely loans for a variety of purposes and at a reasonable interest rate. Moreover, SHGs are the building blocks of organisation of the rural poor. Not only does it help women to become financially self-reliant, the regular meetings of the group provide a platform to discuss and act on a variety of social issues such as health, nutrition, domestic violence etc.
- A typical SHG has 15-20 members from one neighbourhood who meet and save regularly, from Rs 25 to Rs 100 or more each.
- Group responsibility replaces collateral: the group decides the loans and the group is answerable for repayment.
- SHG meetings also become a platform for acting on health, nutrition and domestic violence.
Key Concepts
- Barter system
- A system in which goods are exchanged directly for goods without the use of money.
- Double coincidence of wants
- The requirement in barter that what one person wishes to sell is exactly what the other wishes to buy.
- Medium of exchange
- Anything that acts as an intermediate in the exchange process, splitting an exchange into a sale and a purchase; money's central function.
- Currency
- Paper notes and coins, issued in India by the Reserve Bank of India on behalf of the central government, which no one may legally refuse in settlement.
- Demand deposits
- Deposits in bank accounts that can be withdrawn on demand, and which count as money because they are widely accepted as a means of payment.
- Cheque
- A paper instructing the bank to pay a specific amount from a person's account to the person named on it.
- Credit
- An agreement in which the lender supplies the borrower with money, goods or services in return for the promise of future payment.
- Debt trap
- A situation in which a borrower cannot repay and must borrow again, so that credit pushes them into a position from which recovery is very painful.
- Terms of credit
- The interest rate, collateral and documentation requirement, and mode of repayment that together define a loan agreement.
- Collateral
- An asset owned by the borrower - land, building, vehicle, livestock, bank deposits - used as a guarantee until the loan is repaid, and saleable by the lender on default.
- Formal sector credit
- Loans from banks and cooperatives, whose functioning is supervised by the Reserve Bank of India.
- Informal sector credit
- Loans from moneylenders, traders, employers, relatives and friends, supervised by no organisation and generally far more expensive.
- Reserve Bank of India
- The central bank that issues currency, supervises formal lenders, monitors their cash balances and requires them to lend to small borrowers.
- Self Help Group (SHG)
- A group of 15-20 members, usually rural women of one neighbourhood, who save regularly, lend to each other, and become eligible for a bank loan in the group's name.
- Group responsibility
- The principle that makes SHG lending possible - the group decides and guarantees repayment, so banks will lend without collateral.
Practice Questions
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What is the double coincidence of wants, and how does money remove it? / आवश्यकताओं का दोहरा संयोग क्या है, और मुद्रा इसे कैसे दूर करती है?
Show answer
In barter, double coincidence of wants means both parties must want exactly what the other has to offer at the same time; money removes this by acting as a medium of exchange, so a person can sell goods for money and use that money to buy what is needed. / वस्तु-विनिमय में आवश्यकताओं का दोहरा संयोग का अर्थ है कि दोनों पक्षों को एक ही समय में ठीक वही चाहिए जो दूसरे के पास है; मुद्रा विनिमय के माध्यम के रूप में कार्य कर इसे दूर कर देती है, जिससे व्यक्ति वस्तुएँ बेचकर मुद्रा प्राप्त कर सकता है और उस मुद्रा से अपनी ज़रूरत की वस्तु खरीद सकता है।
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Why is the rupee accepted as a medium of exchange in India? / भारत में रुपये को विनिमय के माध्यम के रूप में क्यों स्वीकार किया जाता है?
Show answer
The rupee is accepted because it is authorised by the government of India and the Reserve Bank of India issues currency notes on behalf of the government, and the law legally accepts it as a medium of payment that cannot be refused in settling transactions. / रुपये को इसलिए स्वीकार किया जाता है क्योंकि यह भारत सरकार द्वारा प्राधिकृत है और भारतीय रिज़र्व बैंक सरकार की ओर से करेंसी नोट जारी करता है, तथा कानून इसे भुगतान के माध्यम के रूप में वैध रूप से स्वीकार करता है जिसे लेन-देन निपटाने में अस्वीकार नहीं किया जा सकता।
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How do banks use the deposits of people to extend loans? / बैंक लोगों की जमाराशियों का उपयोग ऋण देने के लिए किस प्रकार करते हैं?
Show answer
Banks keep only a small portion of their deposits as cash to pay depositors who may come to withdraw money, and use the major portion to extend loans to borrowers, charging a higher interest on loans than they pay on deposits, the difference being their main income. / बैंक अपनी जमाराशियों का केवल एक छोटा भाग नकद के रूप में रखते हैं ताकि निकासी हेतु आने वाले जमाकर्ताओं को भुगतान कर सकें, और अधिकांश भाग का उपयोग उधारकर्ताओं को ऋण देने में करते हैं, ऋण पर जमा की तुलना में अधिक ब्याज लेते हैं, और यही अंतर उनकी मुख्य आय है।
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Define terms of credit and list any two components. / ऋण की शर्तें परिभाषित कीजिए और कोई दो घटक बताइए।
Show answer
Terms of credit are the conditions under which a loan is given, including the interest rate, collateral (security), documentation and the mode of repayment, which together vary depending on the lender and the borrower. / ऋण की शर्तें वे स्थितियाँ हैं जिनके अंतर्गत ऋण दिया जाता है, जिनमें ब्याज दर, समर्पण (प्रतिभूति), दस्तावेज़ीकरण और चुकौती का तरीका शामिल हैं, जो ऋणदाता और उधारकर्ता के अनुसार भिन्न होते हैं।
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Explain with an example how credit can be a debt-trap for poor farmers. / उदाहरण सहित समझाइए कि किस प्रकार ऋण गरीब किसानों के लिए ऋण-जाल बन सकता है।
Show answer
If a farmer borrows at high interest to grow a crop and the crop fails due to poor rains or pests, he cannot repay and may be forced to sell his land or borrow more, sinking deeper into debt; thus in this situation credit pushes him into worse circumstances. / यदि कोई किसान ऊँचे ब्याज पर फसल उगाने के लिए उधार लेता है और खराब वर्षा या कीटों के कारण फसल नष्ट हो जाती है, तो वह चुका नहीं पाता और उसे अपनी ज़मीन बेचनी पड़ सकती है या और उधार लेना पड़ सकता है, जिससे वह कर्ज में और डूब जाता है; इस प्रकार इस स्थिति में ऋण उसे बदतर परिस्थिति में धकेल देता है।
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Distinguish between formal and informal sources of credit with one example each. / ऋण के औपचारिक और अनौपचारिक स्रोतों में एक-एक उदाहरण सहित अंतर कीजिए।
Show answer
Formal sources, such as banks and cooperatives, are supervised by the Reserve Bank of India and charge lower interest, while informal sources, such as moneylenders and traders, have no supervision and often charge very high interest. / औपचारिक स्रोत, जैसे बैंक और सहकारी समितियाँ, भारतीय रिज़र्व बैंक की देखरेख में होते हैं और कम ब्याज लेते हैं, जबकि अनौपचारिक स्रोत, जैसे साहूकार और व्यापारी, किसी देखरेख में नहीं होते और प्रायः बहुत ऊँचा ब्याज लेते हैं।
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How do Self-Help Groups (SHGs) help poor people, especially women, meet their credit needs? / स्वयं सहायता समूह (SHGs) गरीब लोगों, विशेषकर महिलाओं को, उनकी ऋण आवश्यकताएँ पूरी करने में किस प्रकार सहायक हैं?
Show answer
Members of an SHG save small amounts regularly to build a common fund from which they can take small loans at reasonable interest without collateral; after a period the group becomes eligible for bank loans, providing self-employment and reducing dependence on moneylenders. / SHG के सदस्य नियमित रूप से छोटी राशि बचाकर एक साझा कोष बनाते हैं, जिससे वे बिना समर्पण के उचित ब्याज पर छोटे ऋण ले सकते हैं; एक अवधि के बाद समूह बैंक ऋण के योग्य हो जाता है, जिससे स्वरोजगार मिलता है और साहूकारों पर निर्भरता घटती है।
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A farmer borrows ₹5,000 at 5% per month interest to be repaid after one year. How much total interest will he pay, and what does this show about informal credit? / एक किसान एक वर्ष बाद चुकाने हेतु 5% प्रति माह ब्याज पर ₹5,000 उधार लेता है। वह कुल कितना ब्याज चुकाएगा, और यह अनौपचारिक ऋण के बारे में क्या दर्शाता है?
Show answer
Monthly interest = 5% of 5,000 = ₹250; for 12 months total interest = 250 × 12 = ₹3,000, meaning he repays ₹8,000 in all; this shows that informal credit at very high interest rates makes borrowing extremely costly for the poor. / मासिक ब्याज = 5,000 का 5% = ₹250; 12 महीनों के लिए कुल ब्याज = 250 × 12 = ₹3,000, अर्थात वह कुल ₹8,000 चुकाता है; यह दर्शाता है कि बहुत ऊँची ब्याज दर वाला अनौपचारिक ऋण गरीबों के लिए उधार लेना अत्यंत महँगा बना देता है।
Related Laws & Principles
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