Money as a medium of exchange
Before money there was the barter system — directly exchanging goods and services. The problem: it required a double coincidence of wants. A wheat farmer who needs shoes must find a shoemaker who wants wheat — otherwise no exchange happens. Money solves this by being accepted by everyone.
Four functions of money
- Medium of exchange — eliminates double coincidence;
- Measure of value — common unit (rupees, dollars);
- Store of value — can be saved for the future;
- Standard of deferred payment — basis for loans and credit.
Evolution of money
Cattle, grain, salt, cowrie shells → metallic money (gold, silver) → paper money (gold-backed) → fiat money (declared legal tender) → bank deposits → plastic cards → digital money (UPI, wallets) → CBDC (Digital Rupee).
In India, the rupee is legal tender. Coins are issued by the Government of India; notes by the RBI under the RBI Act 1934.
Modern forms of money
- Currency — paper notes (₹10 to ₹500; ₹2,000 withdrawal initiated 2023) and coins;
- Deposits with banks — savings, current, fixed; ~80% of broad money;
- Demand deposits — can be withdrawn via cheque, UPI, debit card; function as money;
- UPI (Unified Payments Interface) — launched April 2016 by NPCI; ~14 billion transactions/month, world's largest real-time payment system;
- Digital wallets — Paytm, PhonePe, Google Pay, Amazon Pay; built on UPI rails;
- Credit and debit cards — RuPay (NPCI), Visa, Mastercard;
- Central Bank Digital Currency (CBDC) — Digital Rupee piloted by RBI from December 2022 in wholesale and retail formats.
All forms of modern money rest on trust — that the central bank guarantees notes, that banks will honour deposits, that the government regulates the system.
Bank deposits and loans — how banks work
People keep money in bank deposits because they earn interest and are safe. Banks keep only a small fraction (typically 10-15%) as cash on hand to meet daily withdrawals. The rest they lend out as loans — to farmers, small businesses, large industries, home buyers.
This is where the magic happens: banks pay interest on deposits and charge higher interest on loans. The difference (interest spread) is the main source of bank income.
Because most deposits never get withdrawn at the same time, banks can lend out much more than the cash they have on hand. This is the basis of credit creation.
Reserve Bank of India — the apex regulator
Established 1 April 1935; nationalised 1 January 1949. India's central bank.
| Function | What it does |
|---|---|
| Issue of currency | Sole authority to issue notes (except ₹1 coin/notes) |
| Banker to government | Manages central government accounts, debt, forex |
| Banker to banks | Lender of last resort; manages reserves |
| Credit control | CRR, SLR, repo rate; controls money supply |
| Forex management | Under FEMA 1999; reserves ~$650 billion |
| Bank regulation | Under Banking Regulation Act 1949 |
| Monetary policy | 6-member MPC; inflation targeting 4% ±2% |
| Payments system | RTGS, NEFT, UPI oversight |
RBI also requires commercial banks to lend at least 40% to priority sectors — agriculture (18%), MSME, education, housing, weaker sections. This is the policy tool that pushes formal credit toward the poor.
Current Governor: Sanjay Malhotra (since December 2024); previous Governor Shaktikanta Das (2018-2024).
Credit — what it means, terms of credit
Credit refers to an agreement in which a lender supplies the borrower with money, goods, or services in return for the promise of future payment.
Terms of credit
Every loan agreement specifies four things:
- Interest rate — the cost of borrowing;
- Collateral — asset (land, building, jewellery, deposits) that the borrower pledges, which the lender can claim if loan is not repaid;
- Documentation — papers proving identity, income, ownership;
- Mode of repayment — instalments, lump sum, frequency.
Together these terms vary substantially between formal and informal sources, with major consequences for the borrower.
Formal vs informal credit — the fundamental divide
| Dimension | Formal credit | Informal credit |
|---|---|---|
| Lenders | Banks, cooperatives | Moneylenders, traders, employers, relatives |
| RBI supervision | Yes | No |
| Interest rate | 8-15% p.a. (lower for priority) | 24-60%+ p.a. |
| Documentation | Extensive | Minimal |
| Collateral | Required | Often informal/personal |
| Disbursal speed | Slow | Fast |
| Coverage (rural) | ~50% | ~50% |
| Risk of debt trap | Low | High |
Excessive reliance on informal credit creates the debt trap — high interest leads to inability to repay; new loans taken to service old ones; assets pledged repeatedly. This is one of the structural causes of farmer suicides in India.
Policy push toward formal credit
- RBI's 40% priority sector lending mandate;
- PMJDY (Pradhan Mantri Jan Dhan Yojana, 2014) — 51+ crore zero-balance bank accounts;
- MUDRA Yojana — small business loans up to ₹10 lakh;
- Kisan Credit Card (KCC) — for farmers;
- Digital lending platforms;
- SHG-Bank Linkage.
Self-Help Groups — credit without collateral
An SHG is a group of 15-20 people (mostly women) who:
- Meet regularly;
- Save small amounts (₹50-200/month) into a common pool;
- Lend from the pool to members at fair interest;
- After 6-12 months of regular operation, apply to a bank for a loan (typically 2-4× group savings);
- Recover loans through peer pressure and group accountability.
The SHG movement began in India in the 1980s and was institutionalised by NABARD in 1992 through the SHG-Bank Linkage Programme. Today, ~1.4 crore SHGs with ~13 crore members operate in India (NRLM data).
Major SHG networks:
- Kudumbashree (Kerala) — world's largest women-only network;
- IKP / Mission Bhagiratha (AP / Telangana);
- NRLM / DAY-NRLM (national).
SHGs solve the collateral problem with group accountability. They also empower women, build social capital, and serve as a platform for political participation.
Grameen Bank Bangladesh — Muhammad Yunus and microfinance
Muhammad Yunus founded the Grameen Bank in Bangladesh in 1983, providing tiny loans (~$100) to poor rural women — without collateral, organised in groups of five, recovered through peer responsibility.
Results:
- ~9 million borrowers, ~96% repayment rate;
- Yunus won the Nobel Peace Prize 2006 with the Bank;
- Inspired the global microfinance movement, including India's SHG system.
The Grameen model proved a powerful policy insight: the poor are credit-worthy when given the right institutional design. The collateral problem can be solved by group-based accountability rather than physical assets.
NCERT exercise solutions — selected answers
Q1. In situations with high risks, credit might create further problems for the borrower. Explain.
Credit in high-risk situations can push borrowers into a debt trap. Example: a small farmer borrows from a moneylender to buy seeds and fertiliser. If the harvest fails (drought, pest attack), the farmer cannot repay. The moneylender charges compound interest; the original loan grows. To repay it, the farmer borrows again — usually at higher interest. This cycle continues until the farmer is forced to sell land or assets. Many farmer suicides in India are connected to this debt trap. CONCLUSION: credit can be helpful (working capital, education, business expansion) only when the borrower has reasonable expectation of repayment and the lender is regulated. In high-risk situations with informal lenders, credit becomes a destructive force.
Q2. How does money solve the problem of double coincidence of wants? Explain with an example.
BARTER requires that both parties want what the other has — the double coincidence of wants. Example: a shoemaker wants wheat but the wheat farmer doesn't want shoes — exchange fails. MONEY solves this because everyone accepts it. The shoemaker sells shoes to whoever wants them, receives money; uses that money to buy wheat from the wheat farmer (who in turn uses the money to buy something he/she wants — say, cloth). Money becomes a universal medium that allows multilateral exchange without requiring any two specific parties to want each other's goods.
Q3. How do banks mediate between those who have surplus money and those who need money?
Banks accept DEPOSITS from people who have surplus money. They pay interest on these deposits. They keep only a small fraction (typically 10-15%) as cash reserves to meet daily withdrawals. The rest, they LEND out to borrowers who need money — for farming, business, housing, education. The bank charges higher interest on loans than it pays on deposits — this 'spread' is the bank's main income. Because most depositors do not withdraw at the same time, banks can confidently lend out more than they have in cash. This intermediation is critical: it MOBILISES savings, channels them to PRODUCTIVE USES, and creates more economic activity than would otherwise be possible.
Q4. Look at a 10-rupee note. What is written on top? Can you explain this statement?
'I promise to pay the bearer the sum of Ten Rupees' — signed by the Governor of the Reserve Bank of India. This statement means that the RBI guarantees the value of the note — anyone holding it can demand that the RBI exchange it for equivalent value. The RBI is the SOLE AUTHORITY for issuing currency notes in India (under the RBI Act 1934). The promise is what makes the note acceptable as MONEY — it is BACKED BY THE SOVEREIGN. This is the essence of FIAT MONEY — it is money because the government says it is, and people trust the government's promise.
Q5. Why do we need to expand formal sources of credit in India?
(1) FORMAL credit charges LOWER INTEREST RATES, reducing the cost of borrowing; (2) Informal lenders charge 24-60%+; the resulting debt traps cause SEVERE HARDSHIP especially among poor farmers and small businesses; (3) Formal credit is REGULATED by RBI — protections exist against unfair practices; (4) Formal credit supports BIGGER INVESTMENTS — farm equipment, business expansion, housing, education; (5) Greater access to formal credit increases ECONOMIC GROWTH and reduces inequality; (6) Currently only ~50% of credit is formal, particularly low in rural areas — needs to expand; (7) PMJDY, MUDRA, SHGs, KCC are tools to expand formal credit.
Q6. What is the basic idea behind the SHGs for the poor? Explain in your own words.
The basic idea behind SHGs is that POOR PEOPLE CAN BE CREDIT-WORTHY when organised into accountable groups. Traditional banking requires COLLATERAL (land, jewellery, deposits) which most poor people lack. So banks refused to lend to them — leaving them at the mercy of moneylenders. SHGs solve this by: (1) Grouping 15-20 people (mostly women); (2) Pooling small savings; (3) Lending from the pool first; (4) Building a savings/repayment track record over 6-12 months; (5) Banks then lend to the GROUP — relying on PEER PRESSURE for repayment, not collateral. The group is jointly responsible for loan recovery — members ensure each other repays. RESULTS: high recovery rates (typically 95%+), women empowerment, financial inclusion, and graduation from informal to formal credit.
Q7. What are the reasons why banks might not be willing to lend to certain borrowers?
Banks may not lend to certain borrowers because of: (1) LACK OF COLLATERAL — poor borrowers usually don't have land or other assets to pledge; (2) LACK OF DOCUMENTATION — many lack income proofs, business records; (3) HIGH PERCEIVED RISK — small farmers face crop failure risk; small businesses face market risk; banks see them as risky; (4) HIGH COST OF SMALL LOANS — administrative cost of a small loan is the same as a big loan, but profit is much less; banks prefer larger loans; (5) DISTANCE — many banks are concentrated in urban areas; rural borrowers cannot easily access; (6) STIGMA — poor borrowers, women, scheduled castes face discrimination. RBI's 40% priority sector lending mandate, the JAM trinity (Jan Dhan-Aadhaar-Mobile), MUDRA, and SHG-Bank linkage are designed to overcome these obstacles.
UPSC PYQ tagging
UPSC angle
Money & Credit is foundational for GS-3 Indian Economy. Recurring sub-themes: monetary policy, financial inclusion, microfinance/SHGs, priority sector lending, RBI tools (CRR/SLR/repo). Strong answers cite RBI's role, the formal-informal divide, NPA issues, and the Jan Dhan-Aadhaar-Mobile (JAM) framework.
- 2018 GS-3: "Examine the role of microfinance institutions in promoting financial inclusion. To what extent has the Self-Help Group model addressed the rural credit gap?"
- 2020 GS-3: "Define the term 'Non-Performing Assets' (NPAs). Discuss the policy measures undertaken to deal with NPAs in the Indian banking sector."
- 2024 GS-3: "What is Digital Rupee (CBDC)? Examine its potential to transform India's payments and monetary architecture."
- 2017 GS-3: "What are the salient features of inclusive growth? Has India been experiencing such a growth process? Analyse and suggest measures for inclusive growth." (credit access dimension)
- Likely 2026: "Discuss the role of Self-Help Groups and microfinance in achieving women's financial inclusion in India."