Money and Credit Essentials

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Money as a Medium of Exchange Definition: Money acts as an intermediate in the exchange process, making transactions easier and more efficient. Eliminates Double Coincidence of Wants: In a barter system, both parties must have what the other desires to sell/buy. Money breaks this direct link, allowing people to sell goods for money and then use that money to buy desired goods. Historical Context: Before money, people used various commodities like grains, cattle, shells, or metals for exchange. Functions of Money: Medium of exchange Measure of value (unit of account) Store of value Standard of deferred payment Modern Forms of Money 1. Currency Includes paper notes and coins. Unlike older forms (gold, silver, cattle, grain), modern currency is fiat money – it has no intrinsic value of its own and is not backed by a commodity. Its value comes from government decree. Legal Tender: It is accepted as a medium of exchange because it is authorized by the country's government. In India: The Reserve Bank of India (RBI) issues currency notes on behalf of the central government. Indian law legalizes the use of Rupee as a medium of payment, which cannot be refused. No individual in India can legally refuse a payment made in rupees. 2. Deposits with Banks People deposit extra cash in bank accounts. Banks accept deposits and pay interest. Money is safe and earns interest. Depositors can withdraw money on demand. These are called demand deposits . Cheque Payments: Demand deposits facilitate payments via cheques. 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. Demand deposits, along with currency, constitute money in the modern economy because they are widely accepted as a means of payment. Loan Activities of Banks Banks keep a small proportion (e.g., 15% in India, as per RBI regulations) of their total deposits as cash to meet withdrawal demands from depositors. This is known as the Cash Reserve Ratio (CRR) . The major portion of deposits is extended as loans. Banks mediate between depositors (those with surplus funds) and borrowers (those who need funds). Income Source: Banks charge a higher interest rate on loans than what they offer on deposits; the difference between these two rates is their main source of income. This difference covers operational costs and generates profit. This process allows banks to create credit and facilitate economic activity. Credit (Loan) Definition: An agreement where the lender supplies money, goods, or services to the borrower in return for a promise of future payment, usually with interest. Two Credit Situations: Positive Role (e.g., Salim's festival order): Credit helps meet working capital needs, complete production on time, expand business, and increase earnings. It can be vital for economic growth. Negative Role (e.g., Swapna's crop failure): If the borrower fails to repay due to unforeseen circumstances (e.g., crop failure, business loss), credit can push them into a debt-trap , leading to greater debt and economic ruin. This is known as a high-risk situation. Terms of Credit: These are the conditions under which a loan is given. Interest Rate: The amount charged by the lender for the use of assets, typically expressed as a percentage of the principal. Collateral (Security): An asset (land, building, vehicle, livestock, bank deposits, property titles) owned by the borrower that is used as a guarantee to a lender until the loan is repaid. If the borrower defaults, the lender has the right to sell the collateral to obtain payment. Documentation Requirement: Specific papers and information required by the lender (e.g., proof of income, address, employment details). Mode of Repayment: The schedule and method by which the loan is to be repaid (e.g., monthly installments, lump sum). Formal Sector Credit in India Sources: Banks (commercial banks, regional rural banks) and cooperatives (cooperative societies). Supervision: The Reserve Bank of India (RBI) supervises the functioning of formal sector lenders. RBI monitors that banks actually maintain the cash balance (CRR). RBI ensures banks give loans not just to profit-making businesses and traders but also to small cultivators, small-scale industries, small borrowers, etc. Periodically, banks have to submit information to the RBI on how much they are lending, to whom, and at what interest rate. Cost: Generally lower interest rates compared to informal sources, leading to lower debt burden. Distribution: Richer households receive a disproportionately larger share of formal credit due to their ability to provide collateral and fulfill documentation requirements. Poor households still rely heavily on informal sources. Necessity: Expansion of formal credit, especially in rural areas, is crucial to reduce dependence on informal sources and ensure equitable distribution of credit, fostering economic development. Informal Sector Credit Sources: Moneylenders, traders, employers, relatives, friends, landlords. Supervision: There is no organization that supervises the credit activities of informal lenders. They can lend at any interest rate. Cost: Much higher interest rates (often exorbitant) compared to formal lenders, leading to high debt burdens and increasing the chances of borrowers falling into a debt trap. Accessibility: Often more accessible to the poor, especially in rural areas, due to personal knowledge between lender and borrower, lack of collateral requirement, and quick disbursement. Exploitation: Informal lenders often use unfair means to get their money back, and their high interest rates can severely exploit borrowers. Self-Help Groups (SHGs) for the Poor Purpose: To provide an alternative to informal credit sources for the rural poor, especially women, and to empower them. Structure: Typically 15-20 members from one neighborhood who meet regularly and save regularly (e.g., Rs 25 to Rs 100 or more). Function: Members can take small loans from the group itself to meet their needs at reasonable interest rates. The group decides on the terms of the loan. After 1-2 years of regular savings, if the group is regular in its savings, it becomes eligible for bank loans. The bank provides the loan in the name of the SHG, which is meant to create self-employment opportunities for the members. Benefits: Help borrowers overcome the problem of lack of collateral, which is a major hurdle for the poor in accessing formal credit. Provide timely loans for various purposes (e.g., releasing mortgaged land, buying seeds, housing, sewing machines) at reasonable interest rates. Serve as building blocks for the organization of the rural poor, helping them to become self-reliant. Empower women financially and provide a platform for discussing social and health issues (e.g., health, nutrition, domestic violence). Improve financial discipline among members. Grameen Bank of Bangladesh A pioneering and successful model for providing credit to the poor at reasonable rates, founded by Professor Muhammad Yunus. Started in the 1970s as a small project, it has grown into one of the largest microfinance institutions globally. Over 9 million members (mostly women from the poorest sections) across more than 81,000 villages in Bangladesh. Demonstrates that poor women are reliable borrowers and can successfully run income-generating activities with small loans. Quote by Prof. Muhammad Yunus: “If credit can be made available to the poor people on terms and conditions that are appropriate and reasonable these millions of small people with their millions of small pursuits can add up to create the biggest development wonder.” Previous Year Board Questions & Answers Q1: Why are demand deposits considered money? (CBSE 2017, 2019) Answer: Demand deposits are considered money because: They are widely accepted as a means of payment alongside currency. They can be withdrawn on demand by the depositors. They can be used to make payments directly through cheques without the use of cash, making them a crucial medium of exchange. They are easily transferable. Q2: Explain the role of the Reserve Bank of India in supervising the formal sector credit. (CBSE 2016, 2018) Answer: The RBI plays a crucial role in supervising the formal sector credit by: Monitoring Cash Reserve Ratio (CRR): It ensures that banks maintain a minimum cash balance (e.g., 15% of deposits) to meet daily withdrawal demands. Ensuring Equitable Lending: RBI monitors that banks lend not just to profit-making businesses and large industries but also to small cultivators, small-scale industries, and other small borrowers. Regulating Interest Rates: While banks set their own lending rates, RBI influences them through policy rates and ensures transparency. Information Submission: Banks are required to submit periodic reports to the RBI detailing their lending activities, including the amount lent, to whom, and at what interest rate. Q3: How do Self-Help Groups (SHGs) help borrowers overcome the problem of lack of collateral? (CBSE 2015, 2017) Answer: SHGs help borrowers overcome the problem of lack of collateral in the following ways: Pooled Savings: Members regularly save small amounts, which are pooled together. This collective saving forms a fund from which members can take small loans. Group Guarantee: The SHG acts as a guarantor for its members. When an SHG gets a loan from a bank, it is the group that is responsible for repayment. The regular meetings and discussions allow the group to monitor the repayment of loans. Eligibility for Bank Loans: After a year or two of regular savings and responsible lending/repayment within the group, SHGs become eligible to obtain bank loans without individual members needing collateral. The bank provides the loan to the group, not to individual members directly. Q4: Why is it necessary for banks and cooperative societies to increase their lending in rural areas? Explain. (CBSE 2019) Answer: It is necessary for banks and cooperative societies to increase their lending in rural areas for the following reasons: Reduce Dependence on Informal Sources: Rural poor often rely on informal lenders who charge very high interest rates, leading to debt traps. Increased formal credit can free them from this exploitation. Promote Economic Development: Access to affordable credit helps farmers buy seeds, fertilizers, equipment, and livestock, and enables small entrepreneurs to start or expand businesses, thus boosting rural economic activity and employment. Ensure Equitable Distribution of Credit: Currently, the rich access more formal credit. Increasing formal lending in rural areas ensures that the benefits of credit reach the poor and marginalized sections of society. Prevent Debt Traps: Lower interest rates and flexible terms of formal credit reduce the risk of borrowers falling into debt traps, allowing them to invest and improve their livelihoods. Achieve Financial Inclusion: Extending formal credit to rural areas brings more people into the formal financial system, promoting greater financial stability and reducing vulnerability. Q5: "The credit activities of the informal sector should be discouraged." Support the statement with arguments. (CBSE 2018) Answer: The credit activities of the informal sector should be discouraged due to several negative impacts: High Interest Rates: Informal lenders charge exorbitant interest rates, often much higher than formal sources. This makes repayment difficult and pushes borrowers into a debt trap. Exploitation: There is no organization to supervise informal lenders, allowing them to use unfair means, manipulate accounts, and harass borrowers to recover money. Debt Trap: High interest rates and harsh terms often lead to a situation where borrowers are unable to repay and end up taking more loans, getting caught in a vicious cycle of debt. No Collateral, but High Risk: While informal lenders may not demand formal collateral, they often target vulnerable people and charge rates that make default almost inevitable, leading to loss of assets or livelihood. Hindrance to Development: The burden of high-cost informal credit reduces the disposable income of the poor, restricts their ability to invest in productive ventures, and thus hinders economic development.