Money and Credit

Barter System: The barter system was used before the advent of money. People used to
exchange one thing for another in this system.

Double Coincidence of wants: The double coincidence of wants is the major drawback

of the barter system. It can be very difficult to find a person who can fulfill this
condition. Suppose you want to barter your MP3 player with a game console, then you
need to find a person who wants to barter his game console for an MP3 player.
 

Money

Money is a means by which we can get something in exchange. Initially, coins came into use.
The coins were initially made of precious metals; like gold and silver. When the precious
metals became too precious, ordinary metals were being used for making coins. Paper money
or currency notes gradually took place of coins; although coins of smaller denominations are
still in use.

The currency notes and coins are issued by the government or an authorized body. In India,
the RBI (Reserve Bank of India) issues currency notes. On the Indian currency note, you can
find a statement which promises to pay the bearer the amount which is mentioned on the
currency note.

Advantages of Money:

a. Removes the coincidence of wants.

b. Takes less storage space and is easier to carry.
c. Liquidity of currency is easier.
d. Now-a-days; many instruments are available through which it is not necessary to
physically carry the currency.

Other Forms of Money

Deposits with Banks: Most of the people need only some currency for their daily needs. Rest
of the amount is usually kept as deposit in banks. Money which is kept in a bank is safe and it
 even earns an interest. One can withdraw money from his account as and when required.
Since deposit in the bank account can be withdrawn on demand, these deposits are called
demand deposits.

One can use a cheque; instead of cash to settle payments. Moreover, one can also buy a
demand draft from a bank to make payments.

Credit: Banks keep a small proportion of their deposits as cash with themselves. This is
usually 15% of their deposits as cash. This amount is kept as provision to pay the depositors
who may come to withdraw the money on any day. This amount is enough because only a
small fraction of people come to withdraw money on a given day. The rest of the amount is
used by the banks to give money on credit to people who need the credit. A bank charges
interest on the loan which it gives to its creditors. The interest rate charged by a bank on loans
is higher than the interest rate given by it on deposits. Thus, interest is the main source of
income for banks.

Credit/Debit Cards: Now-a-days, credit/debit cards are in vogue. A debit card allows you to
make payments from the amount which is lying in your bank account. A credit card, on the
other hand, provides money on credit. Payment through credit/debit card is done
electronically and this removes the need of carrying cash.

Terms of Credit

People often need to borrow money for various purposes. Many businessmen need to borrow
to buy raw materials and machineries. Many farmers need to borrow to buy seeds, fertilisers,
farm equipment, etc. People usually buy vehicles and houses by borrowing from banks. Thus,
credit plays an important role in the economy.

Every loan agreement specifies terms and conditions; regarding the rate of interest and term of
payment. In most of the cases, the banks fix an EMI (Equated Monthly Installment) for
repayment of loan.

Collateral: An asset which is owned by the borrower and is used as a guarantee to a lender
until the loan is repaid is called the collateral. Land, house, vehicle, livestocks, deposits with
banks, insurance policy, gold, etc. are examples of assets. If the borrower fails to repay the
loan, the lender reserves the right to sell the collateral to obtain payment.
 Terms of Credit: The terms of credit include rate of interest, collateral and mode of
repayment. The terms of credit varies from one loan agreement to another and also on the
nature of the lender and the borrower.

Sources of Credit

Formal Sector: The formal Sector comprises of banks and cooperative societies.

Informal Sector: The informal sector consists of money lenders and friends and relatives,
merchants and landlords.

The following diagram shows share of different sources of credit in rural households in India
in 2003.

Fig: Sources of Credit for Rural Households in

India in 2003

While the formal sector is bound by the rules and regulations of the RBI and charge the
prevalent rate of interest as per RBI guidelines; the informal lenders are not bound by such
rules. The informal lenders usually charge a very high rate of interest. A higher cost of
borrowing is often detrimental to the borrower. It usually results in a debt trap for the
borrower. The borrower is seldom able to escape the never ending cycle of loan repayment.

Many people are too poor to qualify the requirements of credit-worthiness of banks and
cooperatives. There are many others who may not have enough documents; like residential
certificate or income certificate. Such people are usually at the mercy of informal lenders.
Self Help Groups

Self Help Groups (SHGs) are recent phenomena. An SHG is comprised of small number of
people; like 15 – 20 members. The members pool their savings. The collection is then utilised
to lend small amounts of money which may be required by any of the members. The group
charges interest on the loan. The arrangement of loans through Self Help Groups is also
known as microfinance because the small amount of loan is involved.

It was the Grameen Bank of Bangladesh which began experimenting with microfinance. The
founder of Grameen Bank, Mohammad Yunus was conferred with Nobel Prize in 2006 for his
efforts at improving the lot of the poor.

SHGs have helped immensely in reducing the influence of informal lenders in rural areas.
Many big corporate houses are also promoting SHGs at many places

The RBI controls the Commercial Banks by various instruments like

a) Cash Reserve Ratio (CRR) - It is a specified minimum fraction of the total

deposits of customers, which commercial banks have to hold as reserves either
in cash or as deposits with the central bank. CRR is set according to the guidelines of
the central bank of a country. Presently CRR is 4%

b) Statutory Liquidity Ratio (SLR) - The Reserve Bank of India has mandated
every bank to have a specific proportion of deposits in the form of liquid assets,
excluding the cash reserve ratio called the Statutory Liquidity Ratio (SLR).

Every bank must have a specified portion of their deposits in the form of cash,
gold, or other liquid assets by the day’s end. The ratio of these liquid assets to the
total demand and time liabilities is called the Statutory Liquidity Ratio (SLR).
Time liabilities refer to the liabilities which the commercial banks are liable to
repay to the customers after an agreed period, and demand liabilities are customer
deposits which are repayable on demand . An increase in the ratio constricts the
ability of the bank to inject money into the economy.SLR presently is 18.5%

c) Bank Rate- A bank rate is the interest rate at which a nation's central bank lends

money to domestic banks, often in the form of loans.
The bank rate for the long term
.Managing the bank rate is a method by which central banks affect economic
activity.
Bank Rate is charged against loans offered by the central bank to commercial
 banks,
No collateral is involved while charging Bank Rate
Increase in Bank Rate directly affects the lending rates offered to the customer,
restricting people to avail loans and damages the overall economic growth

 d) Repo Rate -Repo rate is the rate at which the central bank of a country
(Reserve Bank of India in case of India) lends money to commercial banks in the
event of any shortfall of funds.

  Repo rate is used by monetary authorities to control inflation.

 The REPO rate is used to lend money for the short term

 Collateral is involved when Repo Rate is charged.

 Repo Rate is always lower than the Bank Rate.

 Increase in Repo Rate is usually handled by the banks and doesn’t affect
customers directly.

e) Prime Lending Ratio (PLR)- Prime Lending Rate (PLR) is the rate at which

commercial banks charge their customers who are most credit worthy. According
to the Reserve Bank of India (RBI), banks can fix the PLR with the approval of
their Boards. The prime lending rate today is 3.25%.

(ii) These are those ratios and rates that are fixed by RBI and it is mandatory for
all the commercial banks to follow or maintain these rates.

(iii) All these measures control the commercial banks operations and also control
money supply in Indian Economy