Cash Reserve Ratio

• It is a bank regulation that sets the minimum reserves each bank must hold by way of customer deposits and notes.
• These deposits are designed to satisfy cash withdrawal demands of customers
• Deposits are normally in the form of currency stored in a bank vault or with the central bank like the RBI
• CRR is also called the Liquidity Ratio as it seeks to control money supply in the economy

Effects on money supply:

CRR is used as a tool in monetary policy, influencing the country’s economy, borrowing and interest rates

CRR works like brakes on the economy’s money supplyCRR requirements affect the potential  of the banking system to create higher or lower money supply

Let us now understand how CRR requirements affects the potential of banks to ‘create’ higher or lower money supply

CRR and liquidity:

For e.g. say…the CRR is pegged by RBI at 10%. if a bank receives Rs. 100 as deposit, then they can lend Rs. 90 as a loan and will have to keep the balance Rs. 10 in customer’s deposit account
Now, the borrower who has received Rs. 90 as a loan will deposit the same in his bank
The borrower’s bank will now lend out Rs. 81 (Rs. 90 X 90%) and keep Rs. 9 in his deposit account
As this process continues, the banking system can expand the initial deposit of Rs.100 into a maximum of Rs. 1000 (Rs. 100 + Rs. 90 + Rs. 81….=Rs. 1000)

For e.g. say…the CRR is pegged by RBI at 20%. if a bank receives Rs. 100 as deposit, then they can lend Rs. 80 as a loan and will have to keep the balance Rs. 20 in customer’s deposit account

Now, the borrower who has received Rs. 80 as a loan will deposit the same in his bank

The borrower’s bank will now lend out Rs. 64 (Rs. 80 X 80%) and keep Rs. 16 in his deposit account

As this process continues, the banking system can expand the initial deposit of Rs.100 into a maximum of Rs. 500 (Rs. 100 + Rs. 80 + Rs. 64….=Rs. 500)

The higher the cash reserve (CRR) required, the lower the money available for lending
Every time the borrowed money comes into a deposit account of a customer, the bank has to compulsorily keep a part of it as reserves
This reduces credit expansion by controlling the amount of money that goes out by way of loans

This directly affects money creation process and in turn affects the economic activity
Hence central banks in the world increase the requirement of cash reserves whenever they feel the need to control money supply
CRR is increased to bring down inflation which happens due to excessive spending power
Spending power is augmented by loans – if money that goes out as loans is controlled, inflation can be tamed to some extent
Conversely, if the government wants to stimulate higher economic activity and encourage higher spending to achieve economic growth, they will lower CRR
A lower CRR allows the bank to lend more money and will fuel consumption and spending
Thus…banks indirectly enjoy the power to create more money

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