The Reserve Bank of India mandates that banks store a proportion of their deposits in the form of cash so that the same can be given to the bank’s customers if the need arises.
The percentage of cash required to be kept in reserves, vis-a-vis a bank’s total deposits, is called the Cash Reserve Ratio.
The cash reserve is either stored in the bank’s vault or is sent to the RBI. Banks do not get any interest on the money that is with the RBI under the CRR requirements.
Cash Reserve 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.
Cash Reserve Ratio 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 supply.
- CRR 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
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)
Similarly…
- 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)
So…
- 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.
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.
The Cash Reserve Ratio in India is decided by RBI’s Monetary Policy Committee in the periodic Monetary and Credit Policy. The Reserve Bank of India takes stock of the CRR in every monetary policy review, which, at present, is conducted every six weeks.
CRR is one of the major weapons in the RBI’s arsenal that allows it to maintain a desired level of inflation, control the money supply, and also liquidity in the economy.
