MONEY AND CREDIT

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Money

• Money, in the realm of economics, is a fascinating and indispensable concept. It serves as a universally recognized medium of exchange, allowing individuals to trade goods and services efficiently. In this discussion, we will delve into the advantages of money as a medium of exchange, shedding light on its pivotal role in the functioning of modern economies. So, let’s explore the benefits it offers.

Money as a Medium of Exchange

• Money, as a medium of exchange, is a fundamental pillar of our economic systems. It serves as an intermediary that simplifies transactions between individuals in the following ways:
  • Facilitates Trade: Money streamlines trade by acting as a common and accepted medium. It enables people to exchange a wide range of goods and services, eliminating the need for complex bartering systems.
  • Widely Accepted: Money is universally recognized and accepted, making it easy for individuals to engage in transactions with anyone, regardless of their specific needs or offerings. This widespread acceptance fosters economic activity.
  • Eliminates Double Coincidence of Wants: In barter systems, both parties must possess something the other desires, creating a “double coincidence of wants.” Money eliminates this requirement, as it can be used by anyone to acquire what they need.
  • Standard of Value: Money establishes a common measure of value, allowing people to compare the worth of different goods and services. This standardization simplifies pricing and decision-making in economic transactions.
  • Convenience: Carrying money is far more convenient than transporting a variety of goods for trade. This convenience encourages economic interactions and specialization.
  • Promotes Economic Growth: A well-functioning medium of exchange, such as money, reduces transaction costs, encourages specialization, and expands the range of available goods and services. This, in turn, fosters economic growth.
  • Examples: Common examples of money as a medium of exchange include physical forms like coins and banknotes, as well as digital currencies like credit cards and online payment systems.

Modern Forms of Money

• Currency: In today’s world, one of the most recognizable and widely used forms of money is currency. This encompasses paper notes and coins. The central authority, such as the Reserve Bank of India, issues currency notes on behalf of the government. It’s crucial to note that only this designated authority has the authority to create currency. In India, the rupee is the primary currency, serving as a medium of exchange for various transactions.
• Deposits in Banks: Another modern form of money is held in the form of deposits within banks. People deposit their surplus funds in a bank by opening a bank account in their name. Banks accept these deposits and often provide interest on them, which can encourage saving. These deposits can be withdrawn on demand, earning them the name “demand deposits.” What’s interesting is that payments from these accounts are frequently made through checks instead of physical cash.
• Demand Deposits: These are bank account deposits that are readily available for withdrawal upon demand. They provide flexibility for individuals to access their funds when needed.
• Cheques: A cheque is a written instruction to a bank to pay a specific amount from the issuer’s account to the person or entity named on the cheque. It’s a common method of transferring money securely without the need for physical cash.

Loan Activities of Banks

• Loan activities are a pivotal aspect of banking operations, enabling banks to serve as financial intermediaries that connect savers with borrowers. Here’s a detailed overview:
  • Reserve Requirement: Banks keep a portion of their deposits as cash reserves, typically around 15% in India, to meet the needs of depositors who may want to withdraw their money. This practice ensures the stability of the banking system.
  • Loan Extension: The majority of the funds collected by banks are allocated for lending purposes. Banks extend loans to meet the diverse demands of businesses and individuals for various economic activities, including business expansion, home purchases, and more.
  • Interest Rate Differential: Banks typically charge a higher interest rate on the loans they provide compared to the interest paid to depositors. The difference between the interest rates charged to borrowers and the rates paid to depositors constitutes a significant source of income for banks.
  • Profit Generation: The income generated from the interest rate differential between loans and deposits is a key driver of a bank’s profitability. It allows banks to cover their operational costs and generate profits.

Credit

• Credit, in its essence, is an agreement where a lender provides money, goods, or services to a borrower with the promise of future repayment. It plays a crucial role in financial transactions and economic activities, allowing individuals and businesses to access funds that they may not have readily available. Credit creation involves assessing the need for funds, the ability to repay, and the risks associated with the transaction.
• Now, let’s illustrate credit creation through two contrasting examples:
• Credit, in its essence, is an agreement where a lender provides money, goods, or services to a borrower with the promise of future repayment. It plays a crucial role in financial transactions and economic activities, allowing individuals and businesses to access funds that they may not have readily available. Credit creation involves assessing the need for funds, the ability to repay, and the risks associated with the transaction.
• Now, let’s illustrate credit creation through two contrasting examples:
• Salim’s Case
  • Identifying the Need: Salim, a shoe manufacturer, identifies the need for credit to fulfill a large order for the upcoming festival season, requiring more workers and raw materials.
  • Seeking Credit Sources:
    • Supplier Credit: Salim obtains credit from his leather supplier, allowing him to access raw materials without immediate payment.
    • Advance Payment: A customer provides an advance payment for a portion of the order, giving Salim the financial resources for immediate expenses.
  • Utilizing Credit for Production: Salim uses the credit to scale up production and meet the festival season deadline.
  • Reaping Profits and Repayment: Successful delivery of the order leads to profits. Salim repays the borrowed money from the leather supplier and the customer with the earnings.
• Swapna’s Problem
  • Swapna’s situation highlights several challenges associated with credit:
    • Vulnerability to Unforeseen Events: Credit leaves borrowers susceptible to unexpected setbacks, like crop failures, which can make loan repayment challenging.
    • High Borrowing Costs: Borrowing from moneylenders often comes with steep interest rates, increasing the financial burden on borrowers.
    • Debt Accumulation: Failing to repay loans can lead to a cycle of debt, where borrowers take new loans to cover old ones, resulting in a growing burden.
    • Asset Liquidation and Lack of Support: In dire situations, borrowers may have to sell valuable assets, such as land, to settle their debt. The absence of support systems can make recovery difficult.

Credit: Terms of Credit

• Interest Rate: Every loan agreement specifies an interest rate that the borrower must pay to the lender in addition to the repayment of the principal. This rate represents the cost of borrowing and affects the overall expense of the loan for the borrower.
• Collateral (Security): Lenders often require collateral, which is an asset owned by the borrower (e.g., land, building, vehicle, livestock, or bank deposits). This collateral acts as a guarantee to the lender, ensuring that if the borrower fails to repay the loan, the lender can sell the asset to recover the outstanding amount.
• Documentation Requirements: The terms of credit include documentation requirements, which outline the paperwork and legal processes involved in the loan agreement. This may vary depending on the nature of the loan, lender, and borrower.
• Mode of Repayment: The mode of repayment is another crucial aspect of the terms of credit. It specifies how the borrower is expected to repay the loan, whether through periodic installments, lump-sum payments, or other agreed-upon methods.

Formal Sector in India

• Access to affordable and well-regulated credit is crucial for a country’s development. In India, credit comes in various forms, with formal sector loans being a significant part of the financial landscape. Let’s delve into the key points related to formal sector credit:
  • Supervised by Reserve Bank of India: Formal sector loans are extended by banks and cooperatives, and their operations fall under the close supervision of the Reserve Bank of India (RBI). The RBI plays a vital role in regulating and overseeing their functioning, ensuring compliance with established rules and regulations.
  • Information Disclosure: To maintain transparency and accountability, banks are mandated to provide comprehensive information to the RBI regarding their lending activities. This includes details on the volume of loans disbursed, the identity of borrowers, the applicable interest rates, and other pertinent information.
  • Crucial for Development: Access to affordable credit from formal sources is essential for the country’s development. It serves as a cornerstone for economic growth, fostering entrepreneurship, and supporting various sectors by providing capital for investments and business ventures.
  • Transparency and Accountability: The RBI’s supervision and the requirement for information disclosure contribute to the transparency and accountability of the formal sector credit system. This not only safeguards the integrity of the financial system but also promotes responsible lending practices, ultimately benefiting the economy and its stakeholders.

Informal Sector Loans

• Informal sector loans in India represent a significant but often less-regulated segment of the country’s credit landscape. These loans are typically sourced from a variety of non-institutional entities, including moneylenders, local traders, employers, as well as friends and relatives. Unlike the formal sector, where the Reserve Bank of India (RBI) oversees lending institutions, the informal sector operates without such regulatory scrutiny.
• One of the key challenges with informal sector loans is the lack of an overseeing organization to monitor lending practices. This absence of oversight exposes borrowers to potential exploitation, as there is no external authority to ensure fair lending practices. Moneylenders, in particular, may resort to unfair means to recover their money, often charging exorbitant interest rates that can lead borrowers into a cycle of debt.
• Informal loans, while easily accessible, are generally costlier and riskier for borrowers. The absence of formal documentation can also lead to disputes, making it crucial for borrowers to exercise caution and for policymakers to explore ways to provide more affordable and secure credit options to those who rely on the informal sector for their financial needs.

Self-Help Groups

• Self Help Groups (SHGs) have emerged as a significant and transformative force in the lives of the economically disadvantaged. In regions where formal banking institutions are scarce, and the conventional requirements of collateral and documentation pose obstacles to accessing credit, SHGs have become a beacon of hope for the impoverished. These small groups, typically comprising 15-20 members from the same neighborhood, foster savings and provide a lifeline of financial and social support to their members. Let’s explore the notable advantages that SHGs offer to the underprivileged, from addressing the collateral challenge to empowering women and serving as catalysts for community development.
• Collateral Support: SHGs enable borrowers, often from impoverished backgrounds, to access credit without the need for traditional collateral. This is particularly valuable because many poor households lack assets that can be used as collateral.
• Timely and Affordable Loans: SHGs offer members the opportunity to obtain loans promptly and at reasonable interest rates. This helps individuals meet various financial needs, such as investing in income-generating activities, education, or coping with emergencies.
• Empowerment and Organizational Foundation: SHGs serve as the foundational building blocks for organizing rural poor communities. They empower members to collectively address their financial challenges and work towards socio-economic improvement.
• Empowering Women: SHGs often focus on women’s financial inclusion and empowerment. By participating in these groups, women gain financial independence and decision-making abilities, which can lead to improved quality of life.
• Social Platform: SHG meetings provide a platform for members to discuss and take action on a wide range of social issues, including health, nutrition, domestic violence, and education. This not only addresses financial needs but also contributes to community development and welfare.