Chapter 3: Money and Credit

In a barter system goods are exchanged directly for goods. It needs a double coincidence of wants: what one person wants to sell must be exactly what the other wants to buy. Money removes this problem. It acts as an intermediate step: the potter sells pots for money and then buys rice with that money. Because money stands between the two exchanges, it is called a medium of exchange.

Modern money has two forms. Currency means paper notes and coins. They have no use of their own and are not made of precious metal, yet they are accepted because they are authorised by the government. In India the Reserve Bank of India (RBI) issues notes on behalf of the central government, and by law no one can refuse a payment in rupees. The other form is deposits with banks. Because they can be withdrawn on demand they are called demand deposits, and a cheque, which is a paper instructing the bank to pay a sum from the payer's account, lets payments be made without cash. Currency and demand deposits together make up money in the modern economy.

Banks accept deposits from the public and pay interest on them. They keep only a small proportion of deposits as cash, about 5 per cent in India these days, to pay the few depositors who come to withdraw on a given day. The major part of the deposits is used to give loans. In this way banks mediate between those who have surplus funds (depositors) and those who need funds (borrowers). Banks charge a higher interest rate on loans than they pay on deposits, and this difference is their main source of income.

Credit (loan) is an agreement in which the lender gives the borrower money, goods or services in return for a promise of future payment. When credit meets the working capital needs of production, that is, the ongoing expenses, it can raise earnings. But if there is a loss and no support, the borrower may fall into a debt trap, where credit pushes her into a situation from which recovery is very painful. Whether credit is useful depends on the risk in the situation and on whether there is support in case of loss.

Every loan agreement has an interest rate that the borrower pays to the lender along with the repayment of the principal. Lenders may also ask for collateral (security): an asset that the borrower owns, such as land, a building, a vehicle, livestock or bank deposits, which is used as a guarantee until the loan is repaid. If the borrower fails to repay, the lender can sell the collateral to recover the money. The interest rate, the collateral and documentation needed, and the mode of repayment together are called the terms of credit.

Loans come from two kinds of sources. Formal sector loans are from banks and cooperatives. Informal sector lenders are moneylenders, traders, employers, relatives and friends. The Reserve Bank of India supervises the formal sources: banks must keep a minimum cash balance and report how much they lend, to whom and at what rate. No one supervises informal lenders, who charge much higher interest and may use unfair means to recover loans. High cost of borrowing leaves less income for the borrower and can lead to a debt trap. In 2019 commercial banks were the biggest single source of credit for rural households, but moneylenders still gave about 23 per cent.

Many poor people cannot get bank loans because they have no collateral and papers, while moneylenders charge very high interest. A Self Help Group (SHG) is a small group of 15 to 20 members, usually women from one neighbourhood, who meet regularly and pool their savings. Members take small loans from the group at an interest lower than the moneylender's. After a year or two of regular saving the group can get a bank loan in the group's name. The group decides the purpose, amount, interest and repayment, and the group is responsible for repaying, so banks are willing to lend without collateral. The Grameen Bank of Bangladesh, started in the 1970s, reaches poor women with small loans at reasonable rates.