Chapter 3: Money and Credit
This chapter explores the fundamental role of money in modern economies, the functioning of financial systems, and the critical importance of credit accessibility for economic development, with special focus on India's financial inclusion challenges and initiatives. We examine how money evolved from barter to digital forms, how banks create credit, and why access to formal credit remains unequal in India.
1. Understanding Money: From Barter to Digital
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 socioeconomic context. It serves three primary functions: medium of exchange, unit of account, and store of value.
- The Barter Problem: Double coincidence of wants, lack of common measure of value, difficulty in storing wealth, and indivisibility of some goods made barter inefficient. Money emerged as solution to these limitations.
- Evolution of Money Forms: Commodity money (grains, cattle) → metallic coins (gold, silver) → paper currency → bank money (cheques) → digital money (UPI, cryptocurrencies). Each stage increased convenience and reduced transaction costs.
- Modern Money Characteristics: General acceptability, durability, portability, divisibility, uniformity, limited supply (to maintain value). Fiat money (₹, $) has value because government declares it legal tender, not because of intrinsic worth.
Critical Insight: Money's value derives from social trust—people accept it because they believe others will accept it. This makes monetary systems vulnerable to loss of confidence, as seen in hyperinflation episodes where money becomes worthless paper.
2. Historical Development of Money in India
India's monetary history reflects its economic and political evolution:
- Ancient Period: Barter prevalent, cowrie shells used in some regions. Punch-marked coins (6th century BCE) among world's earliest coinage. Gold coins (dinars) during Gupta period.
- Medieval Period: Sher Shah Suri introduced rupee (silver coin) in 1540s, standardized weights and measures. Mughals continued rupee system. Hundis (bills of exchange) facilitated trade credit.
- Colonial Period: Paper currency introduced (1861), RBI established (1935). British extracted gold and silver, causing monetary scarcity. Great Depression (1930s) led to rupee devaluation.
- Post-Independence: Bank nationalization (1969, 1980), demonetization (1978, 2016). Liberalization (1991) reformed financial sector. Recent digital payment revolution (2016 onward).
3. Modern Banking and Financial Sector Evolution
- 14 major banks nationalized (1969), 6 more (1980)
- Branch expansion (8,200 in 1969 to 60,000 in 1990)
- Priority sector lending introduced (40% target)
- Directed credit to agriculture, small industries
- Narasimham Committee reforms (1991, 1998)
- Private and foreign banks allowed
- Technology adoption: ATMs, core banking
- Microfinance institutions expanded
- PMJDY launched (2014): 500 million bank accounts
- UPI introduced (2016): world-leading digital payments
- NBFC crisis (2018) highlighted regulatory gaps
- COVID accelerated digital adoption
4. Formal vs Informal Credit Sources
Credit Source Comparison
| Source | Interest Rates | Collateral | Accessibility | Regulation | Usage Pattern |
|---|---|---|---|---|---|
| Commercial Banks | 8-15% (varies by loan) | Usually required | Documentation heavy, urban bias | RBI regulated | Business, housing, education loans |
| Regional Rural Banks | 7-12% | Flexible, group guarantee | Better rural reach | RBI + NABARD | Agriculture, small business |
| Cooperatives | 9-14% | Minimal, member-based | Good in some states (Gujarat, Maharashtra) | State govt + RBI | Agriculture, dairy, weavers |
| Microfinance | 18-26% | Group liability | Easy for poor, especially women | RBI (NBFC-MFI) | Small business, consumption |
| Moneylenders | 24-60%+ | Land, gold, sometimes人身安全 | Easiest but exploitative | Unregulated | Emergency, consumption, small business |
| Friends/Relatives | 0% or low | Social collateral | Limited by social network | None | Emergency, ceremonies, education |
5. Credit Creation and Financial Inclusion
A. How Banks Create Money
- The Credit Multiplier Process: Banks keep fraction of deposits as reserve (CRR) and lend rest. ₹100 deposit → ₹90 loan → becomes deposit in another bank → ₹81 loan, etc. Theoretical money multiplier = 1/CRR ratio (if 10% CRR, multiplier = 10).
- Central Bank Tools: RBI controls money supply through: CRR (portion of deposits banks must keep with RBI), SLR (portion in government securities), repo rate (RBI lending rate to banks), open market operations (buying/selling government bonds).
- Non-Performing Assets (NPAs): Loans where borrower hasn't paid interest/principal for 90+ days. Indian banks' NPA ratio peaked at 11.5% (2018), declined to 5% (2023) after reforms. High NPAs reduce banks' lending capacity.
B. Financial Inclusion Initiatives
- Pradhan Mantri Jan Dhan Yojana (2014): Zero-balance accounts with RuPay debit card, accident insurance. 500 million accounts opened, ₹2 lakh crore deposits. 55% women account holders.
- Direct Benefit Transfer (DBT): Government subsidies transferred directly to bank accounts. Saved ₹2.73 lakh crore (2014-2022) by eliminating leakages. 316 schemes covered, 900 million beneficiaries.
- Micro Units Development & Refinance Agency (MUDRA): Loans up to ₹10 lakh to non-farm micro-enterprises. 400 million loans sanctioned worth ₹23 lakh crore (2015-2023).
- Payment Systems: UPI processed 10 billion transactions monthly (2023). India leads world in real-time digital payments. Bharat Bill Pay for utility payments, AePS for banking without internet.
The Debt Trap Cycle: Poor households borrowing from informal sources at high interest (3-5% monthly) for consumption or emergencies → use most income to pay interest → borrow more to repay old loans → trapped in perpetual debt. Formal credit access breaks this cycle by providing affordable loans.
6. Money and Credit Memory Aids
Functions of Money: M.U.S. - Medium of exchange, Unit of account, Store of value. Remember: "Money Usually Succeeds" for three functions.
RBI Monetary Tools: C.S.R.O. - CRR, SLR, Repo rate, Open market operations. Remember: "Central Systems Regulate Operations" for policy tools.
Credit Sources Spectrum: B.C.M.F.R. - Banks, Cooperatives, Microfinance, Friends/Relatives, Moneylenders. Remember: "Best Credit Means Fewer Risks" from formal to informal.
7. Important Financial Institutions
Regulatory and Development Institutions:
- Reserve Bank of India (RBI): Central bank, regulates monetary policy, banking system, foreign exchange. Issues currency, manages foreign reserves, acts as government's banker.
- NABARD (1982): National Bank for Agriculture and Rural Development. Refinances rural banks, promotes rural development, manages Rural Infrastructure Development Fund.
- Small Industries Development Bank of India (SIDBI): Principal financial institution for MSME sector. Refinancing, direct lending, venture capital for small businesses.
- Securities and Exchange Board of India (SEBI): Regulates securities market, protects investors, promotes market development.
Recent Financial Innovations:
- Unified Payments Interface (UPI): Real-time payment system developed by NPCI (2016). Allows instant bank transfers using mobile. Processed ₹17 lakh crore monthly (2023).
- Aadhaar Enabled Payment System (AePS): Banking using Aadhaar authentication, fingerprint. Enables banking in areas without internet or smartphones.
- Account Aggregator Framework: Consent-based data sharing across financial institutions. Allows lenders to access borrowers' financial data (with consent) for better credit assessment.
8. Essential Financial Terminology
Credit: Trust which allows one party to provide resources to another where second doesn't reimburse first immediately but promises either to repay or return those resources later. Essential for economic activity as it allows investment before savings accumulation.
Collateral: Asset that borrower offers as security for loan. If borrower defaults, lender can seize collateral. Land, gold, fixed deposits common collateral in India. Poor often lack acceptable collateral, limiting formal credit access.
Financial Inclusion: Delivery of affordable financial services (savings, credit, insurance, payments) to disadvantaged and low-income segments. Measured by access to bank accounts, credit from formal sources, insurance coverage, digital payments usage.
Digital Divide: Gap between those who have access to digital technology and skills to use it effectively and those who don't. Affects financial inclusion despite digital banking expansion. 40% Indians lack internet access, 50% women lack mobile phones.
Money and Credit Revision Focus
Exam Strategy: For money questions, use historical examples of monetary evolution. For credit questions, compare different sources with advantages/disadvantages. Use Indian data (bank accounts, NPAs, digital transactions). Connect theory (credit multiplier) to practice (bank lending). For policy questions: Problem → Government response → Impact → Remaining challenges.
Note: Money and credit topics connect to current issues: digital currency debates, banking sector health (NPA situation), financial inclusion progress, cryptocurrency regulation. Understanding both traditional banking concepts and fintech innovations is important. Recent focus on digital payments and financial literacy makes practical understanding of UPI, AePS, and account security relevant.
