CRR and its Effects on Money Supply…

In Continuation to CRR Reduction by RBI in the previous post, now it’s time to understand CRR and its Effects on money supply…

CRR Explained

# Cash reserve Ratio (CRR) is the amount of Cash (liquid cash like gold) that the banks have to keep with RBI. This Ratio is basically to secure solvency of the bank and to drain out the excessive money from the banks;

# Cash Reserve Ratio (CRR) 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;

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

# CRR requirements affect the potential of the banking system to create higher or lower money supply;

CRR and its Liquidity…

CRR works like brakes on the economy’s money supply;

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

For e.g. say… When a bank’s deposits increase by Rs100, and the cash reserve ratio is pegged by RBI at 6%, then banks can lend only Rs. 94 as a loan and will have to keep the balance Rs. 6 in customer’s deposit account.

Now, with effect from 28 January 2012, When a bank’s deposits increase by Rs100, and the cash reserve ratio is pegged by RBI at 5.5%, then banks can lend Rs. 94.5 (more by 0.5) as a loan and will have to keep the balance Rs. 5.5 in customer’s deposit account.

So…

1) The lower the cash reserve (CRR) required, the higher the money available with banks for lending and increases liquidity

2) 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;

3) This reduces credit expansion by controlling the amount of money that goes out by way of loans;

4) This directly affects money creation process and in turn affects the economic activity;

5) Hence central banks in the world (It’s RBI in India) increase the requirement of cash reserves whenever they feel the need to control money supply and vice versa.

To sum it up…

<> 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;

Hope you have now understood the concept of Cash Reserve Ratio and its effect / impact on money supply;

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Categories: Banking Basics, Cash Reserve Ratio i.e. CRR