Chapter Notes

MONEY AS A MEDIUM OF EXCHANGE

In our daily lives, we constantly use money to buy goods and services. But have you ever stopped to think why we use money instead of just trading things directly?

Before money existed, people used a barter system, where goods were directly exchanged without the use of money. For this system to work, it required something called a double coincidence of wants. This means that what one person wants to sell is exactly what another person wants to buy.

Money solves this problem by acting as an intermediate step in the exchange process. The shoe manufacturer can first sell their shoes for money and then use that money to buy wheat from any farmer. Because money is accepted by everyone as a form of payment, it eliminates the need for a double coincidence of wants. This role of money is called a medium of exchange.

Early Forms of Money

Long before modern coins and notes, people used a variety of objects as money.

• In early ages, Indians used grains and cattle as money.
• Later, metallic coins made of gold, silver, and copper came into use. These coins had value because they were made of precious metals.

Modern Forms of Money

Today, the money we use is different from the money used in the past. The two main modern forms are currency and bank deposits.

Currency

Modern money includes currency—paper notes and coins. Unlike earlier forms of money, modern currency is not made of precious metals and has no everyday use of its own. A ten-rupee note is just a piece of paper, so why do we accept it as valuable?

The reason is simple: modern currency is accepted as a medium of exchange because it is authorised by the government of the country.

• In India, the Reserve Bank of India (RBI) issues currency notes on behalf of the central government.
• The law makes the rupee a legal medium of payment that cannot be refused in transactions. This makes it widely accepted.

Deposits with Banks

People also hold money as deposits with banks. Instead of keeping all their cash at home, people deposit extra money in a bank by opening an account. This has two main benefits:

• The money is safe with the bank.
• The bank pays an interest amount on the deposits.

People can withdraw this money whenever they need it. Because these deposits can be withdrawn on demand, they are called demand deposits.

Cheque Payments

Demand deposits offer a key feature that makes them a form of money: the ability to make payments using a cheque. A cheque is a paper that instructs the bank to pay a specific amount from a person's account to another person.

LOAN ACTIVITIES OF BANKS

What do banks do with the money that people deposit? They don't just keep it locked away. Banks in India keep only a small portion of their deposits as cash with themselves (around 15 percent). This is to ensure they can pay depositors who might come to withdraw money on any given day.

Banks use the major portion of the deposits to extend loans for various economic activities. In this way, banks act as mediators between two groups:

1. Depositors: Those who have surplus funds.
2. Borrowers: Those who are in need of funds.

Banks charge a higher interest rate on loans than what they offer on deposits. The difference between these two rates is the main source of income for the bank.

TWO DIFFERENT CREDIT SITUATIONS

Credit (loan) refers to an agreement where a lender supplies a borrower with money, goods, or services in return for the promise of future payment. Credit can play a very different role depending on the situation.

A Positive Role for Credit

In some situations, credit can help increase earnings and improve a person's condition.

Credit and the Debt-Trap

In other situations, especially high-risk ones, credit can push a borrower into a situation from which recovery is very difficult. This is often called a debt-trap.

TERMS OF CREDIT

Every loan agreement has a set of conditions, which are called the terms of credit. These include:

• Interest rate: The amount the borrower must pay in addition to the principal amount.
• Collateral: An asset that the borrower owns (like land, a building, a vehicle, or deposits with banks) and uses as a guarantee to the lender until the loan is repaid. If the borrower fails to pay, the lender has the right to sell the collateral to get their money back.
• Documentation requirement: The paperwork needed, such as proof of employment or salary.
• Mode of repayment: How the loan will be paid back (e.g., in monthly instalments).

These terms can vary greatly depending on the lender and the borrower.

Variety of Credit Arrangements

Let's look at an example from the village of Sonpur to see how terms of credit can differ.

• Shyamal, a small farmer, needs a loan for cultivation. He borrows from a local moneylender at a very high interest rate of 5 percent per month (60 percent per year). He also has to promise to work on the moneylender's fields and sell his crop to him after the harvest. The terms here are very harsh.
• Arun, a medium farmer, has seven acres of land and gets a loan from a bank. The interest rate is much lower at 8.5 percent per year, and he can repay it anytime in the next three years. Because he has land to offer as collateral, he can access cheaper credit.
• Rama, a landless agricultural labourer, needs credit for daily expenses when she has no work. She depends on her employer, a landowner, who charges 5 percent interest per month. She repays the loan by working for him and is often stuck in a cycle of debt, taking new loans before the old ones are paid off.

Loans from Cooperatives

Besides banks, another major source of cheap credit in rural areas are cooperative societies (or cooperatives).

• Cooperatives are formed by members who pool their resources. Examples include farmers' cooperatives, weavers' cooperatives, etc.
• A cooperative accepts deposits from its members. It then uses these deposits as collateral to obtain a large loan from a bank.
• These funds are then used to provide loans to its members for various purposes like buying agricultural tools, loans for cultivation, or for building houses.

FORMAL SECTOR CREDIT IN INDIA

Loans can be grouped into two categories based on their source.

1. Formal Sector Loans: These are loans from banks and cooperatives. The Reserve Bank of India (RBI) supervises the functioning of formal lenders. The RBI ensures that banks not only lend to profitable businesses but also to small farmers, small-scale industries, and other small borrowers. Banks have to report to the RBI on their lending activities.

2. Informal Sector Loans: These are loans from moneylenders, traders, employers, relatives, and friends. There is no organization that supervises the credit activities of informal lenders. They can charge whatever interest rate they choose and can use unfair means to get their money back.

The cost of informal loans is much higher than formal loans. This high cost of borrowing can trap people in debt and prevent them from starting businesses or improving their lives.

Formal and Informal Credit: Who gets what?

Studies show a clear pattern in who gets which type of loan.

• In urban areas, poor households take 54 percent of their loans from informal sources. In contrast, rich households take only 17 percent of their loans from informal sources.
• A similar pattern exists in rural areas. Rich households can access cheap credit from formal lenders, while poor households have to rely on expensive informal loans.

This suggests two major issues:

1. The formal sector still meets only about half of the total credit needs of rural people.
2. Formal credit is not distributed equally. The poor, who need it most, are often left out.

SELF-HELP GROUPS FOR THE POOR

Why do poor households still depend so much on informal credit? A major reason is the lack of collateral. Banks usually require collateral for loans, which many poor people do not have. Informal lenders, on the other hand, often know the borrowers personally and are willing to lend without collateral, though at very high interest rates.

To solve this problem, a new approach has emerged: Self-Help Groups (SHGs).

• A typical SHG consists of 15-20 members, usually women from the same neighborhood.
• They meet and save regularly, with savings per member varying from Rs 25 to Rs 100 or more.
• Members can take small loans from the group's own savings to meet their needs. The interest rate is lower than what moneylenders charge.

After a year or two of regular savings, the SHG becomes eligible for a loan from a bank. The loan is sanctioned in the name of the group and is used to create self-employment opportunities for its members.