Money and Credit — Notes

Money as a Medium of Exchange

Money is anything that is widely accepted as a medium of exchange in transactions. It acts as an intermediary that eliminates the need for direct exchange of goods and services.

The Problem of Barter

• Barter System: An economic system where goods and services are directly exchanged for other goods and services without the use of money.
• Double Coincidence of Wants: A crucial requirement for a barter system to work. It means that the person selling must want what the person buying is offering, and vice versa.
• Example: A shoe manufacturer wants to trade shoes for wheat. In a barter system, they would need to find a farmer who not only has wheat to sell but also wants to buy shoes. This direct match is often difficult to find.

How Money Solves the Problem

Money eliminates the need for a double coincidence of wants by providing a common and widely accepted intermediary.

1. Seller Accepts Money: The shoe manufacturer sells shoes for money.
2. Buyer Spends Money: The manufacturer then uses that money to buy wheat from a farmer.

This two-step process (sell for money, buy with money) is far more efficient than trying to find someone who wants shoes and has wheat simultaneously.

Historical Forms of Money

Before modern currency, various items were used as money, accepted because of their intrinsic value or general acceptability within a community:

Modern Forms of Money

Modern money consists of currency and bank deposits.

Currency

• Definition: This includes paper notes and coins issued by the government.
• Why it's Accepted:
• Government Authorization: Currency is issued and authorized by the Reserve Bank of India (RBI) on behalf of the central government.
• Legal Tender: Indian law declares the rupee as legal tender, meaning it cannot be legally refused as a medium of payment for settling debts and transactions within India.
• Key Feature: Modern currency has no intrinsic value of its own (unlike gold coins) and is not of everyday use like grains. Its acceptance relies entirely on trust in the issuing authority and the legal framework.

Deposits with Banks (briefly mentioned as a modern form, detailed in Section 2)

• Demand Deposits: These are funds held in bank accounts that can be withdrawn on demand by the account holder, typically via cheque or withdrawal slip. They are also accepted as a medium of exchange.

Remember

The acceptance of modern currency is based on legal authority and public trust, not on its material value.

Exam-smart

A question might describe a situation where someone is forced to accept a payment in a specific form of money (like rupees). You would need to identify this as the legal tender aspect of money and explain why it's accepted, referencing the government's role and the law.

Deposits with Banks

People hold money not just as currency but also as deposits in banks. This is particularly useful for those who have more cash than they need for daily expenses.

How Deposits Work

• Depositing Extra Cash: Individuals, like workers receiving monthly salaries, can deposit their surplus cash into a bank account.
• Bank's Role: Banks accept these deposits and, in return, pay an interest amount to the depositors. This ensures that the money is safe and grows over time.
• Withdrawal Facility: Depositors can withdraw their money whenever they need it.
• Demand Deposits: Because these deposits can be withdrawn on demand, they are known as demand deposits.

Role of Banks in the Economy

Banks play a crucial role in managing money beyond just safekeeping:

• Keeping a Reserve: Banks hold only a small fraction of their deposits as cash reserves. In India, this is typically around 5% of total deposits. This is to meet the immediate withdrawal needs of depositors.
• Extending Loans: The major portion of the deposits is used by banks to provide loans to individuals and businesses who need funds for various economic activities.
• Mediating Funds: Banks act as intermediaries, connecting those with surplus funds (depositors) and those who need funds (borrowers).
• Source of Income: Banks charge a higher interest rate on the loans they provide than the interest they pay on deposits. The difference between these rates is their primary source of income.

Cheque Payments

Cheques are an important modern form of payment that leverages demand deposits.

• What is a Cheque? A cheque is a written instruction from a bank account holder to their bank to pay a specified amount of money from their account to another person or entity.
• How it Works:

1. A payer, who has a bank account, writes a cheque for a specific amount, naming the payee (the person to whom the payment is due).
2. The payee deposits this cheque into their own bank account.
3. The bank then transfers the amount from the payer's account to the payee's account.

• Significance: Cheque payments allow for transactions to be settled without the physical exchange of cash. This makes it a convenient and secure method for making payments.
• Money in Modern Economy: Because demand deposits can be used for payments via cheques and are widely accepted, they are considered a part of the money supply in the modern economy, alongside currency.

Remember

Demand deposits, with their facility of withdrawal on demand and use in cheque payments, function as money because they fulfil the role of a medium of exchange.

Exam-smart

A question might present a scenario where a person has surplus cash and asks what they can do with it. The answer would involve depositing it in a bank to earn interest and ensure safety, highlighting the concept of demand deposits. Another scenario could involve two parties settling a payment; if a cheque is involved, understanding the process of cheque clearing and its relation to demand deposits would be key.

Loan Activities of Banks

Banks play a crucial role in the economy by acting as intermediaries between those who have surplus funds and those who need funds. They accept deposits from the public and use a major portion of these deposits to grant loans to borrowers. This process is fundamental to economic activity, facilitating investment and consumption.

Banks make profits by charging a higher interest rate on loans than they offer on deposits. This spread between lending and deposit rates is their primary source of income. For example, a bank might pay 4% interest on savings deposits but charge 9% interest on a business loan. The 5% difference covers the bank's operating costs and provides profit.

Remember

Banks do not keep all deposited money idle; they lend out a significant portion to earn interest and stimulate economic activity.

Two Different Credit Situations

Credit, also known as a loan, is an arrangement where a lender provides money, goods, or services to a borrower with the promise of future repayment. Credit can be beneficial, enabling individuals and businesses to undertake projects they otherwise couldn't. However, it can also lead to difficulties if not managed properly.

Situation 1: Salim the Shoe Manufacturer

Scenario: Salim, a shoe manufacturer, receives a large order for 3,000 pairs of shoes to be delivered within a month. To fulfill this order, he needs to:

• Hire additional workers for stitching and pasting.
• Purchase raw materials like leather.

Credit Utilisation: Salim obtains loans from two sources:

1. Supplier Credit: He arranges with the leather supplier to receive leather on credit, promising to pay later. This is a form of deferred payment.
2. Advance Payment: He receives an advance payment from the large trader for 1,000 pairs of shoes, with the condition to deliver the complete order by month-end. This advance acts as a short-term loan.

Outcome: By using credit effectively, Salim can manage his production expenses, complete the order on time, make a good profit, and repay his loans.

Role of Credit: In this case, credit serves as working capital, helping Salim meet ongoing production expenses. It plays a vital and positive role, enabling him to increase his earnings and expand his business.

Situation 2: Swapna the Small Farmer

Scenario: Swapna, a small farmer, cultivates groundnuts on her land. She takes a loan from a moneylender to cover the expenses of cultivation, hoping her harvest will be sufficient to repay the loan.

Challenges and Outcomes:

• Crop Failure: Midway through the season, pests damage the crop. Despite using expensive pesticides, the crop fails.
• Inability to Repay: Swapna cannot repay the moneylender, and the debt grows over the year into a larger amount.
• Cycle of Debt: The following year, she takes a fresh loan. Even with a normal crop, her earnings are insufficient to clear the old debt.
• Debt Trap: Swapna gets caught in a debt trap, where the accumulated debt forces her to sell a part of her land to repay it.

Role of Credit: This situation highlights the risks associated with credit, especially for vulnerable individuals like small farmers who face uncertainties in their income. When credit is not productive or when unforeseen circumstances arise, it can lead to a worsening financial situation and loss of assets.

Exam-smart

Case study questions might present scenarios similar to Salim or Swapna, asking you to identify the role of credit, the type of credit used (e.g., working capital, advance payment), and the potential positive or negative outcomes for the individuals or businesses involved. You'll need to explain how credit either facilitated success or led to a debt trap.

Terms of Credit

Credit refers to a loan, which is an agreement where the lender provides funds to the borrower with the promise that the borrower will repay the money, usually with interest, at a future date. The specific conditions under which a loan is provided are known as the terms of credit. These terms are crucial as they determine the cost of borrowing and the risks involved for both the borrower and the lender.

Every loan agreement specifies several key components that constitute the terms of credit:

1. Interest Rate

• The interest rate is the cost of borrowing money. It is the additional amount that the borrower must pay to the lender along with the principal amount (the original loan amount).
• It is usually expressed as a percentage of the principal amount per year. For example, an annual interest rate of 10% means that for every ₹100 borrowed, the borrower has to pay ₹10 in interest over a year.
• Why it matters: A higher interest rate makes the loan more expensive, increasing the total amount the borrower has to repay. Conversely, a lower interest rate reduces the burden on the borrower.

2. Collateral

• Collateral is an asset owned by the borrower that is pledged to the lender as security for the loan.
• It acts as a guarantee for the lender. If the borrower fails to repay the loan, the lender has the right to sell the collateral to recover their money.
• Examples of collateral: Land titles, buildings, vehicles, livestock, and bank deposits are common forms of collateral.
• Why it matters: Collateral reduces the risk for the lender. Lenders are more willing to lend if they have a security to fall back on in case of default. For borrowers, pledging collateral means they could lose a valuable asset if they cannot repay.

3. Documentation Requirement

• Lenders often require documentation from the borrower to assess their creditworthiness and ability to repay.
• This typically includes proof of identity, address, income (like employment records and salary slips for a housing loan), and details of assets.
• Why it matters: Documentation helps the lender verify the borrower's information and make an informed decision about whether to grant the loan and on what terms. For borrowers, it can be a time-consuming and sometimes difficult process, especially for those with informal income sources.

4. Mode of Repayment

• This refers to how and when the loan is to be repaid. It can involve:
• Lump sum payment: The entire loan amount and interest are paid back at the end of the loan term.
• Installments: The loan is repaid in smaller, regular payments (e.g., monthly, quarterly) over the loan period. These installments usually include a portion of the principal and the interest.
• Why it matters: The repayment schedule affects the borrower's cash flow. Easy repayment terms (like regular, manageable installments) make it easier for borrowers to manage their finances and repay the loan without strain.

The Impact of Terms of Credit on Borrowers: The Debt Trap

The terms of credit significantly influence whether a loan is beneficial or detrimental to the borrower. When these terms are unfavorable or when unforeseen circumstances arise, borrowers can fall into a debt trap.

A debt trap is a situation where a borrower is unable to repay their loan and the accumulated interest, leading them to take new loans to repay old ones. This cycle can worsen over time, trapping the borrower in a spiral of increasing debt.

Example of a Debt Trap:

• Swapna, a farmer, needed credit for crop production. She borrowed from a moneylender at a high interest rate and had to repay after harvest.
• However, crop failure due to expensive pesticides and unfavorable climate meant her earnings were insufficient to repay the loan.
• The debt grew larger due to accumulating interest. To repay the old loan, she took a new one, which also became difficult to repay.
• Ultimately, Swapna had to sell a portion of her land to clear the debt, leaving her worse off than before. Credit, instead of helping her, pushed her into a severe financial crisis.

In contrast, if credit is used effectively and the borrower has a good income to repay, it can be highly beneficial.

Example of Beneficial Credit:

• Megha took a housing loan from a bank to buy a house. The loan had a clear interest rate (12% per annum), a defined repayment period (10 years in monthly installments), collateral (the house papers), and documentation requirements.
• With her employment and salary records, she qualified for the loan. The regular monthly installments allowed her to manage the repayment alongside her income.
• This credit enabled Megha to acquire a valuable asset, improving her financial well-being.

The terms of credit vary depending on the lender (bank, cooperative, moneylender, trader) and the borrower's circumstances and needs.

Remember

The terms of credit determine the cost and risk of a loan. Favorable terms usually mean a low interest rate, easy repayment conditions, and minimal collateral and documentation. Unfavorable terms or unexpected events can lead to a debt trap.

Exam-smart

Case study questions often present scenarios similar to Swapna or Megha, asking you to identify the terms of credit involved (interest rate, collateral, repayment mode) and analyze whether the credit was beneficial or led to a debt trap based on the given information. You might also be asked to suggest ways to improve the borrower's situation.

Variety of Credit Arrangements

Credit, or loans, can come from many different sources, each with its own set of terms (the conditions of the loan). These sources are broadly divided into two main categories: formal sector loans and informal sector loans.

Formal Sector Credit in India

Formal sector loans are those provided by institutions that are regulated and supervised by a central authority, typically the Reserve Bank of India (RBI). These institutions include banks and cooperative societies.

• How it works:
• Banks and cooperatives accept deposits from the public.
• A portion of these deposits is kept as cash reserves (as mandated by the RBI), and the rest is used to provide loans to borrowers.
• The RBI monitors these institutions to ensure they maintain required cash balances and lend responsibly.
• Banks are encouraged to lend to a variety of borrowers, including small farmers, small-scale industries, and individuals, not just profitable businesses.
• The interest rates charged by formal lenders are generally lower and more regulated.
• Why it matters:
• Cheaper credit: Formal loans typically have lower interest rates, making borrowing more affordable.
• Regulation and fairness: The RBI's supervision ensures that banks operate within legal frameworks and do not charge exorbitant rates or engage in unfair practices.
• Development: Access to affordable credit from the formal sector is crucial for economic development, enabling people to grow crops, start businesses, and set up industries.

Informal Sector Credit

Informal sector loans are provided by individuals or institutions that are not regulated or supervised by any central authority.

• Sources of Informal Credit:
• Moneylenders: Individuals who lend money, often at very high interest rates.
• Traders: Business people who may lend money to farmers or other producers, often with the condition that the produce is sold to them.
• Employers: Landowners or business owners who may provide loans to their workers.
• Relatives and Friends: Loans from personal networks.
• Characteristics of Informal Credit:
• High Interest Rates: Informal lenders often charge much higher interest rates compared to banks.
• Unfair Practices: There is no organisation to supervise their credit activities, allowing them to use unfair means to recover money.
• Debt Trap: The high interest rates can lead to borrowers being unable to repay the loan, falling into an increasing debt cycle known as a debt trap.
• No Collateral Flexibility: While some formal loans require collateral, informal lenders might be more flexible initially but compensate with extremely high interest or exploitative terms.

Comparison of Credit Sources

Credit Arrangements in Sonpur Village (Example)

The village of Sonpur illustrates the different credit arrangements available:

• Shyamal (Small Farmer): Likely relies on informal sources like traders or moneylenders, facing terms tied to selling his crop at low prices.
• Arun (Medium Farmer): Has access to formal credit from a bank with a lower interest rate of 8.5% per annum, repayable over three years. He can use collateral (like a cold storage receipt) to secure further loans, demonstrating the advantage of formal sector access.
• Rama (Agricultural Labourer): Has no land and depends entirely on her employer-landowner for credit. She faces extremely high interest rates (5% per month) and a perpetual debt cycle, as she often needs new loans before repaying old ones.

Remember

The primary difference between formal and informal credit lies in regulation and interest rates. Formal credit is cheaper and regulated, while informal credit is expensive and unregulated, often leading to debt traps.

Exam-smart

Case studies involving villagers like Shyamal, Arun, and Rama are common. You'll be asked to compare their credit situations, explain why one has access to cheaper credit than another (e.g., Arun vs. Rama), and identify the risks associated with informal loans, such as debt traps. You might also be given a graph showing credit sources in rural India and asked to interpret it.

Formal and Informal Credit: Who gets what?

The availability and source of credit significantly impact individuals and the economy. Credit, which is borrowing money with the promise to repay it later, often with interest, can be accessed from two main types of sources: formal sector and informal sector.

Formal sector credit comes from institutions like banks and cooperative societies. These institutions are regulated by the Reserve Bank of India (RBI), ensuring they operate under specific rules and supervision. They typically offer loans at reasonable interest rates and require proper documentation and collateral (an asset pledged as security for a loan).

Informal sector credit comes from individuals and entities not regulated by any authority. This includes moneylenders, friends, family, and even employers. Informal lenders often have very high interest rates, may not keep proper records, and can sometimes resort to harassment to recover loans.

Differences Between Formal and Informal Credit

Who Gets What Kind of Credit?

There is a clear disparity in who can access formal and informal credit.

• Rich Households: They primarily rely on the formal sector for their credit needs. This is because they possess the necessary collateral and documentation required by banks, and can therefore avail loans at cheaper interest rates. This allows them to invest in businesses, assets, and further wealth accumulation.
• Poor Households: A significant portion of their credit needs, especially in rural areas, is met by the informal sector. This is often due to:
• Lack of Collateral: They do not own assets that banks would accept as security.
• Documentation Issues: They may lack the required paperwork or proof of regular income.
• Accessibility: Informal lenders are often more accessible and willing to lend small amounts without strict procedures, even if at very high costs.

This situation means that while the rich benefit from affordable credit, the poor are often trapped in a cycle of debt due to high interest rates and exploitative practices of informal lenders.

The Role of Formal Credit in Development

Cheap and affordable credit is crucial for the country's development. When formal institutions increase their lending, especially in rural areas, it can:

• Reduce dependence on informal sources: This protects borrowers from exploitative practices.
• Boost economic activity: People can borrow to start or expand businesses, improve agricultural practices, and create employment opportunities.
• Increase incomes: Cheaper credit allows for profitable investments, leading to higher earnings.

It is therefore essential for banks and cooperatives to expand their lending activities, particularly to those who are currently underserved by the formal sector.

Remember

The formal credit sector plays a vital role in economic development by providing affordable credit. However, its benefits are not equally distributed, with the poor often still dependent on expensive informal credit.

Exam-smart

You might be given a scenario describing a household's income, assets, and loan needs. You will need to determine whether they are more likely to borrow from formal or informal sources, and explain why, referencing concepts like collateral, interest rates, and regulation.

Self-Help Groups for the Poor

To address the credit needs of the poor, especially women in rural areas, new models like Self-Help Groups (SHGs) have emerged.

• Formation: An SHG typically consists of 15-20 members from the same neighbourhood, usually women, who save regularly.
• Savings: Members contribute a small amount (e.g., Rs 25-100 or more) regularly, pooling their savings.
• Internal Lending: Members can take small loans from the group's pooled savings to meet immediate needs. The group charges a nominal interest rate, which is still lower than what moneylenders charge.
• Bank Linkage: After a period of regular savings (1-2 years), the SHG becomes eligible for larger loans from banks. These loans are sanctioned in the name of the group.
• Purpose of Loans: The loans are primarily for creating self-employment opportunities, such as:
• Purchasing seeds and fertilisers for farming.
• Acquiring raw materials for small businesses (e.g., bamboo, cloth).
• Building or improving housing.
• Purchasing assets like sewing machines, handlooms, or cattle.
• Group Decisions: All major decisions regarding savings and loans (purpose, amount, interest, repayment schedule) are made by the group members collectively.
• Repayment Responsibility: The group as a whole is responsible for loan repayment. This peer pressure and collective responsibility ensure high repayment rates.
• Overcoming Collateral Issues: Banks are willing to lend to SHGs because the collective responsibility of the group acts as a form of security, overcoming the lack of individual collateral for the poor members.
• Broader Impact: Beyond financial self-reliance, SHGs also serve as platforms for women to discuss and address social issues like health, nutrition, and domestic violence, empowering them socially.

Remember

SHGs are effective because they pool savings, provide internal credit, facilitate external bank loans, and leverage collective responsibility, thereby helping the poor overcome the lack of collateral and access credit at reasonable rates.

Exam-smart

A case study might describe a group of rural women wanting to start a small business. You might be asked to identify the most suitable credit mechanism for them and explain its advantages, referencing SHGs and their features like pooled savings, collective decision-making, and overcoming collateral issues.