Class 10 Economics · Chapter 3 NotesMoney and Credit

In a barter system, goods are exchanged directly without money. This requires a double coincidence of wants, meaning what one person wishes to sell must be exactly what the other wishes to buy. A shoe manufacturer who wants wheat would have to find a farmer who wants shoes and also has wheat to sell. Money solves this problem. The shoe manufacturer first sells shoes for money and then uses that money to buy wheat. Money acts as an intermediate step in the exchange process, so it is called a medium of exchange. A person holding money can easily exchange it for any commodity or service they want.

• Barterdirect exchange of goods without money
• Double coincidence of wantsboth parties must agree to sell and buy each other's commodities
• Moneyacts as an intermediate in the exchange process

Early Indians used grains and cattle as money. Later, metallic coins of gold, silver and copper were used. Modern currency consists of paper notes and coins. Unlike earlier forms, modern currency is not made of precious metal and has no everyday use of its own. It is accepted as a medium of exchange because it is authorised by the government. In India, the Reserve Bank of India issues currency notes on behalf of the central government. The law legalises the 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.

• Currencypaper notes and coins authorised by the government
• Reserve Bank of India issues currency notes on behalf of the central government
• Rupee cannot be legally refused as a medium of payment in India

People hold money not only as cash but also as deposits with banks. Workers who receive salaries may deposit extra cash in a bank account. Banks accept these deposits and pay interest on them. Since the deposits can be withdrawn on demand, they are called demand deposits. Demand deposits share the essential features of money because they are widely accepted as a means of payment. Payments can be made by cheque instead of cash. 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 is issued. Thus, currency and deposits together constitute money in the modern economy, and both are closely linked to the banking system.

• Demand depositsdeposits that can be withdrawn on demand
• Chequea paper instructing the bank to pay a specific amount from one account to another
• Modern money = currency + demand deposits

Banks keep only a small proportion of their deposits as cash. In India, banks these days hold about 5 per cent of their deposits as cash to pay depositors who may come to withdraw money on any given day. The major portion of deposits is used to extend loans. There is a huge demand for loans for various economic activities. Banks make use of the deposits to meet the loan requirements of 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.

• Banks hold about 5 per cent of deposits as cash
• Banks mediate between depositors and borrowers
• Main source of bank incomedifference between loan interest and deposit interest

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. Credit can play a positive or negative role. In the festival season example, Salim the shoe manufacturer takes loans to hire workers and buy raw materials. He completes production on time, makes a good profit and repays the loan. Here credit helps him increase his earnings. In Swapna's case, a small farmer takes a loan for cultivation, but the crop is hit by pests and fails. She is unable to repay the moneylender and the debt grows. Next year she takes a fresh loan, but earnings are not enough to cover the old loan. She has to sell part of her land to pay off the debt. This is an example of a debt trap. Whether credit is useful depends on the risks in the situation and whether there is some support in case of loss.

• Creditagreement where lender supplies money, goods or services in return for future payment
• Positive rolecredit helps meet working capital needs and increase earnings
• Debt trapcredit pushes the borrower into a situation from which recovery is very painful

Every loan agreement specifies an interest rate which the borrower must pay to the lender along with repayment of the principal. In addition, lenders may demand collateral, which is an asset that the borrower owns (such as land, building, vehicle, livestock, deposits with banks) and uses as a guarantee 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. 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, depending on the nature of the lender and the borrower.

• Collateralan asset that the borrower owns and uses as a guarantee until the loan is repaid
• Terms of creditinterest rate, collateral, documentation requirement, mode of repayment
• Lender can sell the collateral if the borrower fails to repay

Loans can be grouped as formal sector loans and informal sector loans. Formal sector loans include those from banks and cooperatives. Informal lenders include moneylenders, traders, employers, relatives and friends. The Reserve Bank of India supervises the functioning of formal sources of loans. It monitors whether banks maintain a minimum cash balance, and it sees that banks give loans not just to profit-making businesses and traders but also to small cultivators, small-scale industries and small borrowers. There is no organisation supervising the credit activities of lenders in the informal sector. They can lend at whatever interest rate they choose, and there is no one to stop them from using unfair means to get their money back. Compared to formal lenders, most informal lenders charge a much higher interest on loans. Higher cost of borrowing means a larger part of the earnings of borrowers is used to repay the loan, leaving less income for themselves. In some cases, the amount to be repaid is greater than the income of the borrower, leading to increasing debt and debt trap. People who wish to start an enterprise may not do so because of the high cost of borrowing. Therefore, banks and cooperative societies need to lend more, especially in rural areas, so that dependence on informal sources reduces. Formal credit should also be distributed more equally so that the poor can benefit from cheaper loans.

• Formal sectorbanks and cooperatives; supervised by the RBI
• Informal sectormoneylenders, traders, employers, relatives and friends; no supervisor
• Informal loans usually carry higher interest rates and can lead to debt trap

Poor households still depend on informal sources of credit because banks are not present everywhere in rural India and bank loans require proper documents and collateral. Absence of collateral is a major reason preventing the poor from getting bank loans. To solve this, people have organised rural poor, especially women, into small Self Help Groups (SHGs). A typical SHG has 15-20 members who meet and save regularly. Saving per member varies from Rs 25 to Rs 100 or more. Members can take small loans from the group itself, and the group charges interest that is still less than what the moneylender charges. After a year or two, if the group is regular in savings, it becomes eligible for a loan from the bank. Loan is sanctioned in the name of the group and is meant to create self-employment opportunities. The group decides the purpose, amount, interest rate and repayment schedule, and the group is responsible for repayment. Because of this, banks are willing to lend to the poor women when organised in SHGs, even without collateral. SHGs help borrowers overcome the problem of lack of collateral and get timely loans at a reasonable interest rate. They also provide a platform to discuss social issues such as health, nutrition and domestic violence.

• SHG15-20 members, usually women, who save regularly
• Group takes loans from the bank in its own name after regular savings
• SHGs help overcome lack of collateral and promote self-reliance