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Thursday, December 18, 2014

Money And Credit (Class X Standard) : Full Explanation

We will start with an extremely simple question : Why is money necessary? Perhaps you know the answer. For buying goods. For fulfilling the requirements in life. You are right. That is exactly the answer.But we can go a little deeper and answer like this instead - Money acts as an intermediate in the exchange process of goods or commodities and this is the exact reason why it is termed as a medium of exchange.

More specifically,this is a proper definition of money - Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts in a particular country or socio-economic context.

Euro (Coins and Paper Notes,the modern form of money)

Now,let us ask an even more interesting question,what if we did not have money? If we would have needed wheat,then we could go to the wheat seller and ask him for wheat and at the same time 'pay' him with a bunch of bananas or apples.Now,my question is how long would it take you to find out a wheat seller who was ready to give you wheat in exchange of bananas or apples?Time consuming task,isn't it?What if you needed shoes and there is no shoe-seller to sell you shoes in exchange of fruits?Would you leave the country to buy shoes?It is very easy to come to a conclusion from such hypothetical or paradoxical contexts.We need something that would satisfy both the buyer and seller without the existence of double coincidence of wants.
Double coincidence of wants refers to exactly what happened in the above two examples of exchange of fruits with the wheat seller and shoe seller.

Modern Forms Of Money

There are seven basic types or forms of money including : Representative,Fiat,Coinage,Electrical/Digital,Commodity,Paper and Commercial.
However,in the Class X Standard,variants of money have not been explained.There are only two variants of currency denoted : coins and paper notes. (Note : Do not confuse between Money and Currency as absolute synonyms.Currency is used as the synonym in certain circumstances but currency actually refers to money circulated in the form of physical objects.)

Now.the big question is the modern form of money is totally worthless on its own.All printed up and down with unimpressive fonts,it won't even come of use to a five year old's artistic approach.Frustrating.Then what could be the reason of these objects being accepted as money?This is because this is authorised by the government of the country.In India,The Reserve Bank of India issues currency notes on behalf of the central government.As per Indian Law,no other individual or organisation is allowed to issue currency.Moreover,the law legalises the use of rupee as a medium of payment that cannot be refused in settling transactions in India.No individual in India can legally refuse a payment made in Rupees.Hence the rupee is widely accepted as a medium of exchange.

Coins from the times of Queen Victoria

As for why it is paper notes and brass and ferritic stainless steel made coins instead of gold,silver and copper?Actually,the shift to paper money in Europe increased the amount of international trade that could occur. Banks and the ruling classes started buying currencies from other nations and created the first currency market. The stability of a particular monarchy or government affected the value of the country's currency and the ability for that country to trade on an increasingly international market. In simple words,this helps in gaining autonomy towards earning profits in the international markets.

A blank cheque from State Bank of India

The other form in which people hold money are as deposits in banks.The banks always maintain the interest rates to be higher on what they charge on those who take loans to the interest rate they offer on the money deposited by the depositors.This is the main income source of the bank.The bank also keeps a little percentage of money is kept as liquid money (15% in case of India).Sine these deposits can be withdrawn on demand,these deposits are called demand deposits.

Cheques are an interesting facility offered by demand deposits and they instruct the bank to pay a specific amount from a particular person's account to another person's account,to whose name the cheque has been issued. Cheques allow settling of payments without the use of cash.Since cheques also consist of all the essential features of money,they constitute money in the modern economy.


What is Credit?

Credit (loan) refers to an agreement in which the lender supplies the borrower with money,goods or services in return for the promise of future payments.


Case I 

First of all,we will look at the case of Swapna,a farmer. Swapna is a small farmer who grows groundnut on her three acres of land.She takes a loan from the moneylender to meet the expenses of cultivation,hoping that her harvest would help repay the loan.Midway through the season,the crop is hit by pests and the crop fails.Despite spraying her crops with expensive pesticides,Swapna is unable to earn enough profit,which in turn does not allow her to pay the borrowed amount to the moneylender.Next year,she takes a fresh loan and this year the harvest is good but not enough to earn enough profit as to repay the current year's and last year's loan together. Swapna has to sell a part of her land to repay the moneylender the loan she took from him.

Credit in this case pushes the borrower into a situation from which recovery is very painful.

Note : Have you noticed one thing here?The loan a poor farmer in a village takes comes from a moneylender,i.e the informal sector.The moneylender must be charging very high rates of interest which instigates the situation to turn into a  debt trap.

Case II 

It is a festival season two months from now and the shoe manufacturer,Salim,has received an order from a large trader in town for 3,000 pairs of shoes to be delivered in a month time.To complete production on time,Salim has to be delivered in a month time,Salim has to hire a few more workers for stitching and pasting work and purchase the raw materials.To meet his expenses,Salim obtains loans from two sources.First,he asks the leather supplier to supply leather now and promises to pay him later.Second,he obtains loan in cash from the large trader as advance payment for 1000 pairs of shoes with a promise to deliver the whole order by the end of the month.At the end of the month,Salim is able to deliver the order,make a good profit and repay the money that he had borrowed.

Here,credit plays a vital and important role in improving the economic condition of Salim.


Interest rate,collateral and documentation requirement and the mode of repayment together comprise what is known as the terms of credit.


Collateral refers to an asset that the borrower owns such as land,building,vehicle,livestocks,deposits with banks and uses this as a guarantee to a lender until the loan is repaid.

That is,if the borrower is unable to repay the loan,the lender has the right to sell the asset or collateral to obtain payment.

Formal Sector And Informal Sector Credit In India

As of 2003,30% of loan is taken from Moneylenders,27% from Cooperative societies,25% from Commercial Banks,7% from Relatives and Friends,7% from Others,3% from Traders and 1% from Landlords. The debt trap that is caused from taking loans from moneylenders and landlords forces many farmers to lead miserable lives and often results in suicidal cases in India.We will try to look into this matter in one of our next ventures on Economics.

The formal sector of credit consists of loans from banks and cooperatives.The informal lenders include moneylenders,traders,employers,relatives and friends etc.

The Reserve Bank of India supervises the functioning of formal sources of loans.For instance,we have seen that the banks in India keep a comparatively low percentage of cash money/liquid money (the % in Indian banks is 15%.)The RBI actually monitors if this is maintained or not.Similarly,the RBI checks so that the bank does not only give loans to profit-making businesses and traders but also to small cultivators,small scale industries,to small borrowers etc.Periodically,banks have to submit information to the RBI on how much they are lending,to whom,at what interest rate etc.

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  1. Cheques also known as Promissory Notes, promises, promises, when disputes may need be resolved in courts.


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