Chapter 3 Solutions — Money and Credit

Whether credit helps a borrower or pushes him into trouble depends on the risks in the situation and whether there is some support in case of loss. In high-risk situations, if things go wrong the borrower may be unable to repay and the debt grows into a large amount.

The chapter illustrates this through Swapna, a small farmer who took a loan from the moneylender to meet the expenses of cultivating groundnut. Midway through the season the crop was hit by pests and failed. She was unable to repay the moneylender, and the debt grew over the year into a large amount.

Next year she took a fresh loan for cultivation. Even though it was a normal crop, the earnings were not enough to cover the old loan. Caught in debt, she had to sell a part of her land to pay it off. Credit, instead of helping her improve her earnings, left her worse off. This is what is commonly called a debt-trap — credit pushes the borrower into a situation from which recovery is very painful.

Banks accept deposits from the public and pay interest on those deposits, keeping people's money safe with the provision to withdraw it on demand. Banks keep only a small proportion of their deposits as cash with themselves — about 5 per cent — to pay depositors who may come to withdraw money on any given day.

Banks use the major portion of the deposits to extend loans, since there is a huge demand for loans for various economic activities. 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.

On top of the note it is written 'Reserve Bank of India', because in India the Reserve Bank of India issues currency notes on behalf of the central government.

Modern currency has no use of its own — it is not made of precious metal such as gold, silver or copper. It is accepted as a medium of exchange because the currency is authorised by the government of the country.

As per Indian law, no other individual or organisation is allowed to issue currency. Moreover, the law legalises the use of 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. Hence the rupee is widely accepted as a medium of exchange.