NCERT Summary: Money & Credit

Table of Contents
1. Overview
2. Money as a Medium of Exchange
3. Modern Forms of Money
4. Loan Activities of Banks
5. Two Different Credit Situations
6. Terms of Credit
7. Formal and Informal Sources of Credit
8. Self-Help Groups for the Poor
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Overview

• Money is a fundamental economic institution that makes exchange and economic calculation possible.
• Modern forms of money are closely linked to the banking system, which accepts deposits and creates credit.
• Functions of money include its use as a medium of exchange, a unit of account, a store of value and a standard for deferred payments.
• Creation of money largely occurs through banks when they accept deposits and make loans; this process increases the stock of money in the economy.
• Credit is a crucial element of economic life because it allows individuals and firms to undertake production and consumption before they have full funds.
• Access to credit is important for development; ensuring availability of cheap and fair credit to all, especially the poor and rural population, is a major policy concern.

Money as a Medium of Exchange

Money is any widely accepted item or record that people use to buy goods and services and to pay debts. As a medium of exchange it removes the need for a direct barter of goods for goods and thus overcomes the limitations of the barter system.

• Before the widespread use of money, transactions often required a double coincidence of wants - each trader had to want what the other offered. This made exchange difficult and inefficient.
• The introduction of money replaced barter in most transactions because money provides a common measure in which prices and debts can be expressed and settled.

Modern Forms of Money

Currency

• Currency consists of coins and paper notes that are accepted as a medium of exchange for goods and services.
• Modern coins and notes are not made of precious metals; their intrinsic or commodity value is typically less than their face value. Their value rests on legal authority and public confidence.
• Currency in India is authorised by the government and issued by the Reserve Bank of India on behalf of the government. Notes and coins issued by the authorised authority are recognised as legal tender and must be accepted in payments.

Deposits with Banks

• Money held as deposits in banks (current and savings accounts) also functions as money because these deposits can be used to make payments.
• Banks provide facilities such as cheques, electronic transfers and debit cards so depositors can transfer money without using cash.
• Depositors may receive interest on certain types of deposits, and banks use deposited funds to extend loans to others.

Loan Activities of Banks

• Banks act as intermediaries between depositors and borrowers. Depositors place surplus funds with banks and expect a return in the form of interest.
• Banks keep a fraction of deposits as reserves and lend out the remainder to individuals and firms who require funds for consumption or production.
• The interest rate that banks charge borrowers is normally higher than the interest they pay to depositors. The difference is a primary source of a bank's earnings.
• By lending a portion of deposited funds, banks increase the effective supply of money in the economy - this is often described as banks creating credit or creating money.

Two Different Credit Situations

Credit is an agreement in which a lender provides money or goods to a borrower with the expectation that the borrower will repay the amount in the future, usually with interest.

There are two types of credit situation

• A borrower takes a loan for production; production is successful and yields profit; the borrower repays the loan and is better off than before.
• A borrower takes a loan for production; production incurs a loss or yields insufficient income; the borrower cannot repay the loan and falls into a debt trap, becoming worse off than before.

Terms of Credit

• Interest rate: the price of credit. It is agreed when a loan is granted; the borrower repays the principal plus interest according to the contract.
• Collateral: an asset pledged as security for the loan. If the borrower fails to repay, the lender can take possession of the collateral and sell it to recover the outstanding amount.
• Formal lenders typically require documentation (identity, proof of income, purpose of loan) before approving credit. The terms - repayment schedule, rate of interest, collateral requirement - determine the cost and accessibility of credit.

Formal and Informal Sources of Credit

• Credit in an economy comes from two broad sources: the formal sector and the informal sector.
• Formal sector includes banks and cooperative societies that operate under government regulation and supervision. Their lending is governed by legal rules and they normally charge regulated interest rates.
• Informal sector includes moneylenders, traders, employers, relatives and friends. The rate of interest is varying from person to person. There is no organization for supervising loan in informal sector. Lenders can use any method to get back their money from the borrowers. Sometimes, the incomes of the borrowers become less compare than the amount which has to pay due to the high rate of interest.
• In rural and remote areas, formal financial services may be limited or difficult to access. As a result, many households depend on informal lenders and pay high interest, which can reduce their income and increase vulnerability.

• The chart above (placeholder) shows that in many rural areas a large share of credit comes from professional and agricultural moneylenders. For equitable growth, it is important to expand affordable formal credit in rural regions.

Self-Help Groups for the Poor

• When bank branches and formal financial services are unavailable, the poor often turn to informal lenders who demand high interest and may require no formal collateral. Formal loans are difficult to obtain without documentation and collateral.
• A self-help group (SHG) is a small voluntary association of people, typically from the same locality, who pool savings and use the pooled funds to provide loans to members at reasonable rates.
• SHGs typically consist of 15-20 members. Members contribute small amounts regularly - for example, small weekly or monthly savings which can range from a few rupees (e.g. Rs. 25) to larger sums depending on members' capacity.
• Loans from the group are used for a variety of purposes: small income-generating activities, meeting working capital needs, releasing mortgaged land, house repairs, buying productive assets and other household needs.
• Groups often have joint liability mechanisms: if one member defaults, other members take responsibility for repayment; this social collateral reduces the formal collateral requirement and improves repayment discipline.
• SHGs may be linked to banks so that the group as a whole can access larger loans and government development schemes. Linking SHGs to formal finance improves access to affordable credit and supports income generation among the poor.