Money and Credit: Class 10 Economics Chapter 3

The Journey of Money: Overcoming the Barter System

Before money existed, people used the barter system for trade. Barter is the direct exchange of goods and services for other goods and services. For example, a farmer with surplus wheat might exchange it with a potter for some pots. While simple, this system had a major problem: the double coincidence of wants. This means that both parties have to agree to sell and buy each other's commodities. The farmer not only has to find someone who wants to buy wheat but also someone who has the pots that the farmer wants to buy. Imagine how difficult and time-consuming that would be!

Money solves this problem by acting as an intermediate in the exchange process. It serves as a medium of exchange. Now, the farmer can sell the wheat for money and then use that money to buy pots from anyone who is selling them. The potter doesn't need to want wheat; they just need to accept money, which they can then use to buy whatever they need. Because money is generally accepted as a form of payment, it eliminates the need for a double coincidence of wants and makes transactions much smoother.

Understanding Key Concepts in Money and Credit

Money

Anything that is generally accepted as a medium of exchange, a measure of value, a store of value, and a standard for deferred payment.

Demand Deposits

The deposits in bank accounts that can be withdrawn on demand. These are considered money because they are accepted as a means of payment via cheques or digital transfers.

Credit (Loan)

An agreement in which a lender supplies the borrower with money, goods, or services in return for the promise of future payment.

Collateral

An asset (like land, building, vehicle, or livestock) that a borrower owns and uses as a guarantee to a lender until the loan is repaid. If the borrower fails to repay, the lender has the right to sell the collateral to recover the loan amount.

Terms of Credit

The set of conditions under which a loan is given. This includes the interest rate, collateral requirement, documentation, and the mode of repayment.

The Role of Banks: How Loan Activities Work

1. Step 1: Accepting Deposits from the Public — Banks act as a safe place for people with extra cash. Individuals and businesses open accounts and deposit their surplus money. In return, the bank pays a certain amount of interest on these deposits.
2. Step 2: Keeping a Minimum Cash Balance — Banks do not keep all the deposited money with them. As per the guidelines of the Reserve Bank of India (RBI), they are required to maintain a minimum cash balance (for instance, 15% of their total deposits) to handle the day-to-day withdrawal needs of depositors.
3. Step 3: Extending Loans to Borrowers — The major portion of the deposits (the remaining 85%, in our example) is used by banks to give out loans for various economic activities, such as for business expansion, buying a house, or for education.
4. Step 4: Earning Income through Interest Spread — Banks charge a higher rate of interest on loans than what they offer on deposits. The difference between the interest charged from borrowers and the interest paid to depositors is the main source of income for the bank. This process makes banks a financial intermediary.

Exam Tip: Formal vs. Informal Credit - A Key Distinction

A very common question in exams asks you to compare the formal and informal sectors of credit. Remember these key points:

• Formal Sector: Includes loans from banks and cooperatives. They are supervised by the Reserve Bank of India (RBI). They generally charge lower interest rates and have clear, transparent 'terms of credit'.
• Informal Sector: Includes loans from moneylenders, traders, employers, relatives, and friends. There is no organization to supervise them. They often charge much higher interest rates and can use unfair means to get their money back. Borrowing from this sector can easily push a person into a debt trap.

For your exam, always argue that expanding the reach of the formal sector is crucial for the country's development. It provides cheap and affordable credit, which encourages investment and helps the poor to escape the clutches of informal lenders.

Practice Questions with Solutions

• How does the use of money make it easier to exchange things? Give an example. Q: How does the use of money make it easier to exchange things? Give an example. A: Step 1: Explain the problem without money. Without money, people rely on the barter system, which requires a 'double coincidence of wants'. This means you must find someone who has what you want and who also wants what you have. Step 2: Explain how money solves this problem. Money acts as a medium of exchange. It eliminates the need for the double coincidence of wants because it is universally accepted as payment. Step 3: Provide an example. A shoemaker who wants to buy wheat no longer needs to find a farmer who needs shoes. The shoemaker can sell shoes to anyone for money, and then use that money to buy wheat from any farmer who is selling it. Final Answer: Money acts as an intermediary, breaking down a single barter transaction into two separate transactions (selling for money, and buying with money), thus making exchange much easier and more efficient.
• The Reserve Bank of India (RBI) supervises the functioning of formal sources of loans. What are its key supervisory functions? Q: The Reserve Bank of India (RBI) supervises the functioning of formal sources of loans. What are its key supervisory functions? A: Step 1: The RBI ensures that banks maintain a minimum cash balance out of the deposits they receive. This ensures that banks have enough cash to pay depositors who might come to withdraw money. Step 2: The RBI monitors that banks are not just giving loans to profit-making businesses and rich traders, but also to small cultivators, small-scale industries, and small borrowers. Step 3: Banks have to periodically submit information to the RBI on how much they are lending, to whom, and at what interest rate. This ensures transparency and adherence to lending norms. Final Answer: The RBI's key supervisory functions are to ensure banks maintain minimum cash reserves, provide loans to all sectors of the economy (not just the profitable ones), and report their lending activities, thereby maintaining the stability and fairness of the formal financial system.
• Salim wants to take a loan to start a small shoe-making business. He approaches a local bank. What 'terms of credit' is the bank likely to ask for before sanctioning the loan? Q: Salim wants to take a loan to start a small shoe-making business. He approaches a local bank. What 'terms of credit' is the bank likely to ask for before sanctioning the loan? A: Step 1: Identify the components of 'terms of credit'. The terms of credit comprise the interest rate, collateral and documentation required, and the mode of repayment. Step 2: Apply these to Salim's case. The bank will first specify the interest rate on the loan. For example, 9% per annum. Step 3: The bank will require collateral. Since Salim is starting a business, the bank might ask for papers of his house or land as a security against the loan. Step 4: The bank will require documentation like proof of identity, proof of address, and a business plan showing the viability of his shoe-making venture. Step 5: The mode of repayment will be specified, for example, monthly installments (EMI) over a period of 5 years. Final Answer: The bank will likely ask for an interest rate, collateral (like property papers), necessary documentation (ID, address proof, business plan), and a defined repayment schedule as the terms of credit for Salim's loan.
• Why is it necessary for banks and cooperative societies to increase their lending in rural areas? Q: Why is it necessary for banks and cooperative societies to increase their lending in rural areas? A: Step 1: State the problem in rural areas. A large number of people in rural areas still depend on informal sources of credit like moneylenders, who charge very high interest rates and often exploit the borrowers. Step 2: Explain the benefit of formal credit. Cheap and affordable credit from banks and cooperatives can increase incomes. Farmers can use these loans to buy seeds, fertilizers, and equipment, which can lead to better harvests and higher earnings. Step 3: Discuss the broader economic impact. Increased access to formal credit can help in the overall development of rural areas. It can promote small-scale industries, trade, and other non-farm activities, creating more jobs and reducing dependency on agriculture. Final Answer: It is necessary for banks and cooperatives to increase lending in rural areas to free rural households from the exploitation of informal lenders, boost agricultural and non-agricultural productivity, increase incomes, and contribute to the overall economic development of the country.

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