Chapter 3 — Money and Credit

Money solves the problem of double coincidence of wants. In a barter system, a shoe manufacturer wanting wheat must find a farmer who not only has wheat to sell but also wants to buy shoes. Money eliminates this requirement by acting as a medium of exchange—the manufacturer sells shoes for money, then uses money to buy wheat from any seller.

Modern money consists of two forms: (1) currency—paper notes and coins issued by the Reserve Bank of India, which is accepted as a medium of exchange because it is authorized by the government, and (2) demand deposits with banks, which can be withdrawn on demand and used for payments via cheques, making them equivalent to money.

Banks keep only about 5 per cent of deposits as cash reserve to meet daily withdrawal needs. They use the major portion of deposits to extend loans to borrowers. Banks charge a higher interest rate on loans than they pay on deposits; the difference is their main source of income. This allows banks to mediate between depositors (who have surplus funds) and borrowers (who need credit).

Terms of credit include: (1) interest rate—the cost of borrowing, (2) collateral—an asset the borrower pledges as security (land, building, vehicle, livestock, bank deposits), (3) documentation requirements—proof of employment, salary, etc., and (4) mode of repayment—the schedule and method of repaying the loan. These terms vary based on the lender and borrower.

Collateral is an asset the borrower owns and pledges as a guarantee until the loan is repaid. If the borrower fails to repay, the lender has the right to sell the collateral to recover payment. Common examples include land titles, deposits with banks, and livestock. Lenders demand collateral to protect themselves against default risk.

Formal sector credit comes from banks and cooperatives and is supervised by the Reserve Bank of India, which ensures reasonable interest rates and fair lending practices. Informal sector credit comes from moneylenders, traders, employers, and relatives, with no supervision. Informal lenders charge much higher interest rates (often 5-60 per cent per annum), keep no records, and may use unfair means to recover money.

Poor households lack collateral and proper documents required by banks, so they depend on informal sources and pay very high interest rates, limiting their income and ability to start enterprises. Expanding formal credit with reasonable terms would help poor households increase earnings, start small businesses, and participate in economic development.

SHGs are groups of 15-20 rural poor, usually women, who meet regularly to save and pool resources. Members save Rs 25 to Rs 100 per month. After a year or two of regular savings, the group becomes eligible for bank loans in the group's name. The group itself provides small loans to members at lower rates than moneylenders. SHGs help borrowers overcome the collateral problem and provide a platform to discuss social issues like health and domestic violence.

In November 2016, the Indian government declared Rs 500 and Rs 1,000 currency notes invalid and asked people to surrender them to banks in exchange for new notes. This led to a shift toward digital transactions—bank transfers, cheques, ATM cards, credit cards, and UPI systems—to reduce dependence on cash and control corruption.

Yes. Demand deposits share the essential characteristics of money because they can be withdrawn on demand. People can make payments through cheques—the account holder writes a cheque instructing the bank to transfer funds to another person's account. Money transfers from one account to another without any physical cash exchange, demonstrating that demand deposits function as money in the modern economy.

A debt trap occurs when a borrower takes a loan expecting to repay it from future income, but an unexpected loss (e.g., crop failure) prevents repayment. The borrower must take a fresh loan, and the old debt grows. Unable to repay, the borrower may be forced to sell assets (like land). Credit becomes harmful when risks are high and there is no support in case of loss, as happened to Swapna, the farmer whose crop failed due to pests.

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