Money and Credit

Before the introduction of money, Barter system is used to exchange goods and services

o Barter System: A Barter system is an old method of exchange. This method has been
used for centuries and long before money was invented. People exchanged goods and
services for other goods and services in return. Goods are directly exchanged without
the use of money.
o Limitations of Barter System
 Double coincidence of wants: A problem associated with the Barter system is ‘Double
coincidence of wants’. Both parties involved in trade or exchange have to agree to sell
and buy each other’s commodities.
 Complex and time consuming: Another problem was complexity and time
consumption in a barter system. What a person desires to sell is exactly what other
wishes to buy. It takes lot of time.
 Expression of value for goods: Problem arises when goods needs to be expressed in a
definite value or monetary units.

This is how transactions took place in the early times

Barter System

o Money: The use of money spans a very large part of our everyday life. Money acts as an
intermediate in the exchange process. Hence, it is called a ‘medium of exchange’.
o Money has made our transactions more simple and convenient in following ways:
 Money eliminates the need of double coincidence of wants by providing the crucial
intermediate step in the process of exchange in an economy.
 Though time consumption is less in money transactions comparatively, the exchange of
goods and services has now become simple and convenient.
 Money serves as measure of value of goods and services in the terms of monetary unit.
For example: The cost of sugar is 50 Rs/kg. The value of Sugar is simply expressed in
monetary unit.
o Modern forms of money
 Before the introduction of coins, a variety of objects were used as money. For example,
since the very early ages, Indians used grains and cattle as money.
 Thereafter, era of metallic coins – Gold, Silver, Copper coins came which continued till
the last century.
 Modern forms of money include Currency- Paper notes and coins and Demand
deposits.
o Characteristics of Modern currency :
 Unlike the things that were used as money earlier, modern currency is not made up of
precious metals such as gold, silver and copper.
 Unlike grain and cattle, they are neither of everyday use. The modern currency is
without any use of its own.
o Reasons for Wide Acceptance of Currency ( Rupee) as a medium of exchange
 Currency is legally authorized by the Government of India.
 In India, the Reserve Bank of India (RBI) issues currency notes on the behalf of central
government.
 As per Indian law, no other individual or organization is allowed to issue currency and
law legalizes the use of rupee as a medium of payment that cannot be refused in setting
transactions in India.
 No individual in India can legally refuse a payment made in rupees.
o Deposits with the banks
 The form in which people hold money is as deposits with the banks.
 At a point of time, people need only some currency for their day to day needs.
 People deposit extra cash with the banks by opening a bank account in their name.
 Banks accept the deposits and also pay an amount of interest on the deposits.
 By this way, people’s money is safe with the banks and it earns an amount as an
interest.
 People have the provision to withdraw the money as when they require.
o Demand deposits
 The deposits in the bank account which can be withdrawn on the depositor’s demand
are called ‘demand deposits’.
 Demand deposits offer another interesting facility of cheque.
  Cheque: 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. It is a
cashless transaction.
 Demand deposits share the essential features of money. 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 modern economy.
o Loan activities of the banks

A question arises what do the banks do with the deposits which they accept from the public?

 Banks keep only a small proportion of their deposits as cash with themselves e.g. banks
in India these days hold about 15% of their deposits as cash.
 Why banks hold deposits as cash? This is kept as a provision to pay the depositors who
might come to withdraw money from the bank on any given day. Since, on a particular
day, only some of its depositors come to withdraw cash, the bank is able to manage
with the cash.
 Banks make use of the deposits to meet the loan requirements of the people. In this
way, banks mediate people who have surplus funds (the depositors) and those who are
in the 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 the
depositors is the main source of income of the respective bank.

Ple Peoples make deposits People take loans

Depositors

Banks Borrowers

Peoples make withdrawals People repay loans with high interest

And get low interest
Figure: Understanding the interesting mechanism of the bank Income

High Interest on loans paid by borrowers – low Interest on demand deposits given by bank =
Income of the bank

o Credit (loan): Credit refers to an agreement in which the lender supplies the borrower
with money, goods or services in return for the promise of future payment.
o Credit plays a vital and positive role in the following ways:-
 Meets the capital needs: Credit meets the working capital needs of small producers
e.g. farmers take credit to sow his/her crop in different cropping seasons.
 Meets the ongoing expenses: It meets the ongoing expenses of production such as
sprinkling insecticides, pesticides and other fertilizers, irrigation and repair of
equipment to obtain higher productivity.
 Helps in setting up industries: It helps in setting up new industries or business. Setting
up of industries provides employment to peoples and thus fulfilling their basic needs
such as food and shelter and clothing. It provides an alternative source of livelihood and
hence boosts a country’s economy.
 Increases earnings: Credit increases the earning of small producers and Income is the
best indicator and a motivation for future development whether it is of living standard
or basis needs.
 Provides Subsistence: Credit has enough potential to give a homeless individual, a
home. It provides a support for livelihood and sustenance of life.
 Production on time: Credit also helps to complete production of various crops on time.
It provides grains and ensures food security on time. Since FCI procures food grains
from farmers for ensure food security to peoples by providing grains at subsidized
rates, it enhances the functioning of Public Distribution System.
o Negative roles of credit are as follows:-
 Debt trap: Credit can push a borrower in a dept trap, it is a situation in which recovery
or repayment of credit is very painful e.g. during natural calamities, farmers find it
difficult to repay the credit which they have taken.
 Agree to Collateral (Terms of credit): Small producers are compelled to sell a part of
his/her land for repayment of credit. In this case, Repayment of loan is crucially
dependent on the income from production or farming.
 Borrower life: Credit can make a person’s life hell by decrease in his earning and
borrower reaches to worst than before.
o Terms of Credit
 Interest rate, collateral, documentation requirement and mode of repayment together
comprise the ‘terms of credit’

Interest rate: Every loan agreement specifies an interest rate which the borrower must pay to
the lender along with the repayment of the principal.

Collateral: Collateral is an asset that the borrower owns e.g. land, building vehicle, livestock,
deposits with the bank 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 right to sell the asset or collateral
to obtain payment.
 Properties such as land titles, deposits with the bank, livestock are some common
examples of collateral used for borrowing.

Mode of repayment: Repayment can be made in the form of EMI (Equated Monthly
Installments), lump sum cash, gold or any private property.

Documentation requirement: Every loan agreement requires some legal documents such as
Aadhar card, Residential proof, bank statement, salary slip of borrower to prevent
malpractices and to ensure loan security.

 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.
 Credit can obtained from formal as well as informal resources
 The various types of loans can be conveniently grouped as formal sector loans and
informal sector loans
o Formal and Informal sector credit

Formal sector credit Informal sector credit

The formal sector credit includes credit from The informal sector includes credit from informal
formal sources e.g. banks and cooperatives. sources e.g. moneylenders, traders, employers,
relatives and friends.

Organization Supervision: The RBI No Organization Supervision: There is no any

supervises the functioning of formal organization which supervises the credit activities of
resources of loans in formal sector. lenders in the informal sector.

Low interest rate: The Interest rate on the High interest rate: The Interest rate on the loans
loans from formal sources is comparatively from informal sources is comparatively much high.
less.
Lower cost of borrowing: It means Higher cost of borrowing: Borrowers have less
Borrowers have enough income left for income left for themselves for repayment. This can
themselves after repayment. lead the borrower in the situation of dept trap.

No Unfair means: No unfair means are used Unfair Means: Unfair means are repeatedly used to
for profit making. get more profit and money back

Guarantee and Mutual trust: Guarantee and No Guarantee and Mutual trust:
mutual trust between both parties is Guarantee and mutual trust between both parties is
predominately maintained with provision of not maintained. A party can strictly dominate on the
terms of credit. other disregarding terms of credit.

Aim: Their main motive is social welfare. Aim: Their main motive is profit- making.

o Functioning of RBI in the Formal sector loans

 The Reserve Bank of India monitors the banks in actually maintaining cash balance out
of the deposits they receive.
 The RBI sees that the banks give loans not to just 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.

“Cheap and affordable credit is crucial for country’s development”, in following ways:-

i. Higher incomes: Cheap and affordable credit would lead to the higher incomes and
many people could then borrow cheaply for a variety of needs.
ii. Enterprise desires: It would help farmers to grow crops, do business and other
enterprise activities thereby fulfilling all enterprise desires.
iii. Provide Employment: It would encourage people to set up new small scale industries
which would provide employment to large scale unemployed in rural as well as urban
areas.
iv. End of Cycle of debt trap: Farmers can live a happy life and can sustain their family by
generating higher income from affordable credit thus coming out from cycle of dept
trap. There would less cases of suicide in a particular year.
v. Trade and more investment: It would encourage people to invest in trade activities
and more investment will lead to the acceleration of economic activities.
These factors put together would boost and add value to a country’s economy collectively.

 Hence, banks and cooperative societies need to lend more especially in rural areas.
 The informal sector still meets only half of the credit needs of the rural people. The
remaining credit needs are met from informal sources.
o There is urgent need of banks and cooperatives in rural areas so as to ensure:
 To reduce dependency on informal loans: There is an urgency to reduce the
dependence of peoples on informal sector of credit.
 Cheap and affordable loan: Banks must be in rural areas to provide cheaper loans thus
assuring good deal of future.
 Accessibility towards loans: Banks should be established to provide accessibility
towards loans for the poor so as they could be easily within reach of formal loans.
 To reduce exploitation in informal credit: Banks in rural areas will reduce exploitation
of small landless farmers by spectators and middle men.
 Encouraging Food providers (Farmers): Banks in rural areas will encourage farmers to
invest in agriculture, setting up small scale industries and to accelerate economic
activities.
o Self Help Groups ( SHGs) for the poor

Question: Why poor household are still dependent on the informal sources of credit?

 Banks are not present everywhere in rural India.

 Getting a loan from a bank is much more difficult than taking loan from informal
sources.
 Absence of collateral is preventing poor household from getting bank loans. But banks
loans require proper documents and collateral.
 Poor households feel afraid of going to formal institutions.
 There is a lack of awareness (education) in rural areas.
 Informal lenders know the borrowers personally and get persuaded easily to give loan
without collateral.
 The borrowers can approach to informal lenders even without repaying their earlier
loans.

Self Help Groups

 A typical Self Help Group has 15-20 members usually belonging to one
neighbourhood, who meet and pool (collect) their savings.
 Saving per member varies from Rs. 25 to Rs. 100 or more depending on the ability
of the people to save.
  Members can talk small loans from the group itself to meet their needs. However,
group charges interest on these loans but this is still less than what the
moneylender charges.
 After one or two years, if 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.
 Most of the important decisions regarding the savings and loans 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.
 It is the group which is also responsible for the repayment of the loan.

How SHGs ensures repayment of loan?

Any case of non- repayment of loan by any one member is followed up seriously by the
other members of the group. Because of this feature, Banks are willing to lend to the
poor women when organised in SHGs even though they have no collateral as such.

Advantages of Self Help Groups

 The Self Help Groups help borrowers to overcome the problem of lack of
collateral.
 It enables loans for variety of purposes at time and reasonable rate.
 SHGs are the building blocks of organization of the rural poor.
 It helps the women to become self- reliant.
 It provides Women empowerment platform to discuss and act on the variety of
social issues such as health, nutrition, domestic violence etc by regular meetings
within the group.
o Grameen Bank of Bangladesh
 Grameen Bank of Bangladesh is one of the biggest success stories in reaching the poor
to meet their credit needs at reasonable rate.
 It was started in 1970s as a small project by professor Muhammad Yunus. He was the
recipient of 2006 Nobel Prize for peace.
 Grameen Bank in 2018 has over 9 million members in about 81, 600 spread across
Bangladesh.
 Almost all of the borrowers are women and belong to the poorest sections of society.
 These borrowers have proved that not only are poor women reliable borrowers, but
they can start and run a variety of small income generation activities successfully.