Money and Credit – Term II

Important Concepts

  1. Money is anything which is commonly accepted as a medium of exchange and in discharge of debts.
  2. People exchange goods and services through the medium of money. Money by itself has no utility. It is only an intermediary. The use of money facilitates exchange.
  3. Direct exchange of goods against goods without use of money is called barter exchange (i.e. exchange of goods for goods). This is also known as CC economy (i.e. commodity for commodity economy).
  4. Simultaneous  fulfilment  of  mutual  wants  by  buyers  and  sellers  is  known  as  double coincidence of wants. Let us understand this concept with the help of an example :
  5. A shoe manufacturer wants to sell his shoes in the market and buy wheat. Now he has to directly exchange shoes for wheat without the use of money. He would have to look for a wheat growing farmer who not only wants to sell wheat but also wants to buy shoes in exchange.
  6. Before the introduction of coins, a variety of objects   were used as money. For example, since the very early ages, Indians used grains and cattle as money. Thereafter came the use of metallic coins–gold, silver, copper coins. This process was finally taken over by the paper money (which means currency notes). As the volume of transactions increased, even paper money started becoming inconvenient because of time involved in its counting and space required for its safe keeping. This led to the introduction of bank money (credit money) in the forms of cheque, demand drafts, credit cards etc.
  7. The major function of a bank is to give loans, particularly to businessmen and entrepreneurs and thereby earn interest.
  8. Banks get money for providing loans by accepting the deposits from people. Deposits are the lifeline of a bank. These are of two types : time deposits and demand deposits. Time deposits can be withdrawn only after a specified period of time. Demand deposits in the bank can be withdrawn on demand by issuing cheques.
  9. The facility of cheques against demand deposits makes it possible to directly settle payments without the use of cash.
  10. Credit (i.e. giving loans) refers to an agreement in which the lender supplies the borrower with money, goods or services in return for the promise of future payments with interest. Credit plays a vital and positive role in the society. This can be explained further with the help of a suitable example. Saleem obtains loans to meet the needs of production. The credit helps him to meet the need of ongoing expenses of production, complete production in time and thereby increase his earnings.
  11. Sometimes, credit, instead of helping people, pushes them into a debt trap.
  12. In Swapana’s case who is a farmer, the failure of crop made loan repayment impossible. Credit in this case pushes the borrower into a situation from which recovery is painful.
  13. Terms of credit include interest rate, collateral and documentation requirements and the mode of repayment. The terms of credit may vary depending on the nature of the lender and the borrower.
  14. Collateral is an asset that the borrower owns (such as land, building, vehicles, livestock etc.)  and uses this as a guarantee to the lender until the loan is repaid.
  15. Formal credit is generally available with the banks and cooperatives. They charge lesser rates of interest than informal institutions. The Reserve Bank of India (RBI) supervises the functioning of formal sources of loan.
  16. Informal lenders include moneylenders, traders, employers, relatives and friends etc. They charge much higher interest on loans. There is no one to stop them from using unfair means to get their money back.
  17. The idea behind Self-Help Groups is to organise the rural poor into self-help groups and collect their savings. Saving per member varies from Rs 25 to Rs 100 or more depending on the ability of the people to save. Members can take small loans from the group itself to meet their own needs. The group charges less rate of interest on these loans. If the group is regular in savings, it becomes eligible for availing loan from the bank.

Important Questions and Answers

Q.1. How do banks mediate between those who have surplus money and those who need money?

Ans. Banks collect surplus money with people, as deposits. Banks use a major portion of these deposits to extend loans. There is a huge demand for loans by businessmen and industrial houses for various economic activities. Banks may use the deposits to meet the loan requirements of the people. In this way, banks mediate between those who have surplus funds (the depositors) and those who are in need of these funds (the borrowers) and banks charge a higher interest rate on loans than what they offer on deposits.

Q.2. Modern currency is without any use of its own as a commodity. Why is it accepted as money?

Ans. Modern forms of money include paper notes and coins. Modern currency is neither made of precious metals such as gold, silver and copper nor consists of daily use commodities. The modern currency is without any use of its own.

It is accepted as a medium of exchange because the currency is authorised by the government of a country.

Q.3. Why are banks willing to lend to women organised in self-help groups (SHGs)?

Ans. Non-payment of loan by any member of the group is followed up seriously by other members in a group. Because of this feature, banks are willing to lend to the poor women of SHGs, even though they have no collateral as such.

Q.4. Why do you think that the share of formal sector credit is higher for the richer households, compared to the poorer households?

Ans. The share of formal sector credit is higher for the richer households because they can deposit the collaterals (security) such as land, building, livestock etc. while it is difficult for the poorer households because of non-availability of such collaterals.

Q.5. In India, about 80% of farmers are small farmers who need credit for cultivation.

(a)  Why might banks be unwilling to lend to small farmers?

(b)  What are the other sources from which the small farmers can borrow?

(c)  Explain with an example how the terms of credit can be unfavourable for the small farmers. (d)  Suggest some ways by which small farmers can get cheap credit.

Ans. (a)  As the small farmers find it difficult to provide necessary documents / formalities and collateral security required for loan, so these banks might be unwilling to lend to small farmers.

(b)  Informal sources of credit like moneylenders, employers, relatives, friends etc. are the sources from which small farmers borrow the credit.

(c)  If higher rate of interest is carried as terms of credit from informal sources, then it would be unfavourable for the small farmers.

(d)  Farmers can get cheap credit through cooperatives and SHGs.

Q.6. In situations with high risks, credit might create further problems for the borrower. Explain.

Ans. The areas like farming, where high risks are involved, crop failure make loan repayment impossible. To repay the loan amount, farmers have to sell a portion of their land. In such a situation credit pushes the person into a debt-trap from which recovery is very painful.

Q.7. Why do lenders ask for collateral while lending?

Ans. Generally lenders ask for collateral, which is an asset that the borrower owns (such as land, building, vehicle, livestock etc.) and uses this as a guarantee to a lender until the loan is repaid. If borrower fails to repay the loan, the lender has the right to sell the collateral to obtain payments.

Q.8. In what ways does the Reserve Bank of India supervise the functioning of banks? Why is it necessary?

Ans. The Reserve Bank of India supervises the functioning of formal sources of loan. For example, we have seen that the banks maintain a minimum cash balance out of the deposits they receive. The RBI monitors that the banks actually maintain the cash balance. Similarly, the RBI sees that the banks give loans not just to profit making businesses but also to small cultivators, small scale industries etc.

Q.9. Vinay needs a loan to set up a small business. On what basis will Vinay decide whether to borrow from a bank or a moneylender? Discuss.

Ans. If Manav has all the necessary documents showing his paying capacity and collateral security then he will go in for a formal source of credit, i.e. bank. Bank will charge a reasonable rate of interest. If he cannot provide necessary documents required for loan from the bank, then he has to opt for an informal source of credit who sometimes lends at higher rate of interest and uses unfair means to get back the money.

Q.10. Which are two major sources of formal sector credit in India? Why do we need to expand the formal sources of credit?

Ans. Formal sector credit in India includes loans from banks and cooperatives. RBI supervises their functions of giving loans. Lower rate of interest is charged as compared to informal sources of credit on these loans.

Need to expand formal sources of credit : Formal sector credit needs to be expanded in India so as to save people and especially poor farmers and workers from exploitation of the informal sector credit. Formal sector lends at a reasonable rate of interest which is very cheap. Formal credit can fulfil various needs of the people through providing cheap and affordable credit.

Q.11. Write two main functions of a commercial bank.

Ans. Accepting deposits from the individuals and providing loans to the entrepreneurs are the two main functions of a commercial bank.

Q.12. Why should credit at reasonable rates be available for all?

Ans. If credit is available at reasonable rate, this would lead to higher income and many people could then borrow for a variety of needs such as for growing crops, for setting small scale industries, for business etc. Thus credit at reasonalble rate will be helpful in the development process of a country.

Q.13. What do you understand by “terms of credit”?

Ans. Interest rate, collateral and documentation requirement, and the mode of repayment together are called the terms of credit.

Q.14. How is credit helpful for the country’s development?

Ans. Large numbers of transactions in our day to day activities involve credit in some form or the other. Credit helps people to meet the ongoing expenses of production, complete production on time and thereby increase their earnings. Hence, it plays a vital and positive role in a country’s development.

Q.15. What is the basic idea behind the SHG’s for the poor? Explain in your words.

Ans. The basic idea behind the SHG’s for the poor is to provide credit facilities at a cheaper rate and also without much documentation process.

An SHG has 15-20 members, usually from the neighbourhood, who meet and save regularly in the range of Rs 25 to Rs 100 or more. The amount which is collected by an SHG is utlised to give loan to a member of the group. Now the group decides as regards the loans to be granted, the purpose, amount, interest to be charged, and its repayment schedule.

Q.16. Why do we need to expand formal sources of credit in India?

Ans. Formal sources of credit in India provide loans to individuals at far cheaper rates than informal sources of credit. This helps to increase their income and they are able to repay the principal amount as well as interest by parting with a small part of their higher income. It will lead to more production. This helps in the economic development of a country.

Q.17. What is the main source of income for banks?

Ans. The main source of income for banks is the difference between interest rate charged from borrowers and what is paid to depositors. After keeping a portion of deposits as reserves banks lend to people who demand money as loan and bank charges interest from them.

PREVIOUS YEARS’ QUESTIONS

 

Q.1. What do the banks do with the ‘Public Deposits’? Describe their working mechanism.

Ans. Banks  accept  deposits  from  the  Public  and  use  the  major  portion  of  these  deposits  to extend loans. There is a huge demand for loans for various economic activities. Banks make use of these deposits to meet the loan requirement of the people and thereby earn interest. This is, infact, the main source of income of the bank. In this way, bank acts as a mediator 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.

Q.2. What are demand deposits? Describe any three salient features of demand deposits.

Ans. People with surplus money or extra amount deposit it in banks. The banks keep the money safe and give an interest on it. The deposits can be drawn at any time on demand by the depositors. That is why they are called ‘demand deposits’.

(i)  The demand deposits encashable by issuing cheques have the essential features of money.

(ii)  They make it possible to directly settle payments without the use of cash.

(iii)  Since  demand  drafts/cheques  are  widely  accepted  as  a  means  of  payment  along  with currency, they constitute money in the modern economy.

Q.3. Mention any three points of distinction between formal sector loan and informal sector loan.

Formal Sources of Credit

 1. Formal sources of credit are generally provided by banks and cooperatives.

2.  Interest rate for repaying loans is lower.

3.  RBI supervises the functioning of formal sources of loan and also ensures that these facilities should also be given to small cultivators and small borrowers.

Informal sources of Credit

1.  Informal sources of credit are generally provided  by  moneylenders,  traders, employers, relatives and  friends.

2.  Interest rate for repaying loans is costlier.

3.  In informal sector no such organisation is there to supervise the credit activities of lenders that they used to charge higher rate of interest on loans.

Q.4. Differentiate between Reserve Bank of India RBI and Commercial Bank.

Reserve Bank of India

1.  It has the sole monopoly right to issue currency notes.

2.  It is the apex bank in the money market of a country.

3.  It does not deal with the public.

4.  It acts as a banker to the government.

Commercial Bank

1. No such thing is done by commercial bank.

2. It is a unit in the banking structure of the country.

3. It directly deals with the public and business firms.

4. It has no such responsibility towards the state.

Q.5. Explain any two features each of formal sector loans and informal sector loans.

Formal Sector Loans :

Formal sector loans include loans from banks and cooperatives. Features of formal sector loans are :

(i)  Formal sectors provide cheap and affordable loans and their rate of interest is monitered by RBI.

(ii) Formal sector strictly follows the terms of credit which includes interest rate, collateral, documentation and the mode of repayment.

Informal Sector Loans :

Informal sector loans include loans from moneylenders, traders, employers, relatives, friends etc. Features for informal sector loans are :

(i)  Their credit activities are not governed by any organisation, therefore they charge higher rate of interest.

(ii)  Informal sector loan providers know the borrowers personally, and hence they provide loans on easy terms without collateral and documentation.

Q.6. What  are  the  two  main  reasons  for  formal  credit  not  being  available  to  the  rural poor ? Why is there a need to expand rural credit?

Ans. The two main reasons for formal credit not being available to rural poor are :

(i)  Absence of collateral and documentation is the main reason which prevents rural poor from getting bank loans.

(ii) The arrangements of informal sector loans are flexible in terms of timelines, procedural requirements, interest rates etc. They are adjustable according to the needs and convenience of the borrower.

There is a need to expand rural credit from the side of formal sector because : (i)  Informal sectors exploit rural poors by putting them in debt-traps.

(ii) Cheap and affordable credit for rural poors is important for the country’s overall development.

Q.7. Why do the rural borrowers depend on the informal sector for credit? What steps can be taken to encourage them to take loans from the formal sources ? Explain any two.

Ans. The rural borrowers depend on the informal sector for credit because : (i)  Absense of collateral and documentation with rural borrowers.

(ii)  Flexible loans in term of timelines, interest rates, procedural requirements etc. are provided to rural borrowers by informal sectors.

Steps that can be adopted to encourage them to take loans from the formal sources are :

(i)  Awareness among rural borrowers against the exploitation of informal sectors. Need to aware them regarding high rate of interest and debt traps made by such moneylenders.

(ii)  Promotion to self-help groups. These groups collect their savings as per their own ability to save. Members can take small loans from the groups to meet their requirements. If the group is regular in savings for year or two, it can avail loan from the bank.

Q.8. ‘Cheap  and  affordable  credit  is  crucial  for the  country’s  development’.  Explain  the statement with four points.

OR

Why do we need to expand formal source of credit in India ? Explain any four reasons.

Ans. If the loans are cheap and affordable, this can lead to countries development in the following ways :

 

(i)  Cheap loans results in higher incomes and higher profits which can help in the expansion of business.

(ii)  More and more people can be benefitted by the loans in their businesses.

(iii)  This can help in making more and more agricultural activities, small-scale industries etc.

Credit can be distributed more equally which helps in benefitting the poors by the help of cheaper loans.

Q.9. Answers the following questions :

(a)  Why are banks unwilling to lend loans to small farmers ?

(b)  Besides banks, what are the other sources of credit from which the small farmers can borrow.

(c)  Explain how terms of credit can be unfavourable for the small farmers. (d)  From where can small farmers get cheap loans ?

Ans. (a)  Banks provide loans after collateral and documentation securities, which generally the small farmers failed to  comply with. Therefore, banks are unwilling to lend loans to small farmers.

(b)  There  are  several  informal  sources  of  credit  like  landlords,  moneylenders,  traders, relatives and friends etc.

(c)  Terms of informal credit can put the small farmers into debt-traps. Higher rate of interest and unfavourable conditions expit farmers by the situation of multiple loans.

(d)  Farmers can get cheap and safe loans from formal credit providers i.e., banks and co- operative societies.

Q.10. Which are the two major sources of formal sector credit in India ? Why do we need to expand formal sources of credit ?

Ans. The  two  major  sources  of  formal  sector  credit  in  India  are  —  commercial  banks  and cooperative societies.

We need to expand formal sources of credit due to following reasons :

(a)  Informal sources of credit exploit the poors resulting in putting them into debt-traps. (b)  Formal sources of credit are cheaper and thus they help in country’s development.

Q.11. What is meant by term of credit ? What does it include ?

Ans. Terms of credit are the requirements need to be satisfied for any credit arrangements. It includes interest rate, collateral, documentation and mode of repayment. However the terms of credit vary depending upon the nature of lender, borrower and loan.

Q.12. How does the Reserve Bank of India supervise the functioning of banks? Why is this necessary?

Ans. Reserve Bank of India (RBI) supervised the banks in the following ways : (i)  It monitors the balance kept by banks for day-to-day transactions.

(ii)  It checks that the banks give loans not just to profit-making businesses and traders but also to small borrowers.

(iii)  Periodically banks have to give details about lending, borrowers and interest rate to RBI.

It is necessary for securing public welfare. It avoids the bank to run the business with profit motive only. It also keeps a check on interest rate of credit facilities provided by bank. RBI makes sure that the loans from the banks are affordable and cheap.

Q.13. Describe four features of Self-Help Group (SHG).

Ans. The features of Self-Help Group (SHG) are :

(i)  People form their personal groups for the purpose of savings and also lend money among themselves.

(ii)  Rate of interest is lower than informal service  providers.

(iii)  They can also avail loans from banks if their savings are regular.

(iv)  Decisions regarding the savings and loan activities are taken by group members.

Q.14. What is double coincidence of want? How has money solved this problem?

Ans. Things exchanged for other things without the use of money is known as barter system. The barter system laid the foundation of trade but trade was limited to the bounds of a village or town. Hence, in a barter system when both the parties agree to sell and buy each other’s commodities, it is known as double coincidence of wants. Whatever commodity a person desires to sell is exactly what commodity the other wishes to buy. Without double coincidence of wants exchange of goods is not possible. Therefore, it is an essential feature.

Money eliminates the need of double coincidence of wants. One can easily exchange their goods in exchange of money and later on pay money for the desired commodities. Money acts as a intermediate in the process of exchange, it is called as medium of exchange.

Q.15. How do banks mediate between those who have surplus money and those who need money?

Ans. People keep their surplus money in banks for safety and interest which is provided by banks to them. Banks again keep only a small proportion of their cash with themselves. These days banks keep only 15% of the total deposits with them. Rest of the money banks keep to extend loans. Banks charge interest on loans which is higher than the interest on deposits. This surplus interest becomes the source of income for the banks. The 15% of cash deposits which banks keep with themselves helps to carry on with, day-to-day transactions. Like every day, depositors come to withdraw some of their cash.

Q.16. Differentiate between formal and informal sources of credit.

Formal Sources

1.  Formal sources of credit are loans from banks and cooperative societies.

2. Functioning of formal sources of credit is governed by Reserve Bank of India. Their interest rate and money lending details are periodically checked by RBI.

3.  Rate of interest is common and fixed for all formal sources and borrowers.

4.  Formal sources of credit needs to satisfy all the terms of credit before credit, activities.

5.  They provide cheap and affordable credit for both urban and rural borrowers interest.

Informal Sources

1.  Informal sources of credit are money-

lenders,  traders,  employers,  relatives, friends etc.

2.  There is no organisation that manages or check the credit activities performed by informal sources.

3.  Rate of interest depends upon the choice of moneylenders.

4.  Informal sources of credit are flexible in terms of credit.

5.  They generally charge higher rate of interest.