CRR (Cash Reserve Ratio)

World of Finance by M.Vijaya Sai

Banks are more familiar to people these days than food malls, shopping malls as every activity of maximum number of people is been controlled by banks. Banks play a significant role in ones life and the contribution of banks to the nation and the economy is immense. There are hundreds of things about banks which a common man does not know. One such concept is CRR. We all read in the news papers that RBI has increased the CRR limits and the interest rate will go up. But what is the correlation between CRR and the interest rates? What is CRR? Why do they increase or decrease it? Like this, there are many questions. Here is a small article to answer all your queries relating to CRR.

Cash Reserve Ratio mandates that all commercial banks maintain a certain percentage of their total demand and time liabilities with themselves or with the Reserve Bank of India (RBI). This could be in the form of cash reserves or by way of a current account with the RBI. The objective is to ensure the safety and liquidity of the deposits with the banks. The percentage upper limit of the CRR is 15% while there is no lower limit. What is a liability (like in time and demand liability)? Here, a liability is simply a deposit account with a bank. What we call a deposit is called a liability by the bank as the latter would have to repay us. In other worlds, our deposit is our loan to the bank (and hence the interest paid by the bank)

There are two kinds of liabilities (i.e. deposits)

1 Time liability
A time liability is a type of account from which you can withdraw your money only after a specified period of time. Since this kind of an account has a specified term, it is also called a ‘term liability’. An example is a fixed deposit account.

2 Demand liability
A demand liability is an account from which you can withdraw your money on demand.
Example : saving account and current account.

Every bank has to keep a said percentage of such liabilities with RBI. The current CRR is 5.0%. The RBI uses the CRR as an effective tool to increase or decrease money supply in the economy. This way the central bank can also control inflation. How does this work?

CRR as a tool to control inflation
Let us say the RBI increase the CRR. This would mean that banks would have to keep more money with the RBI. This, in turn, would reduce the money available with them, thus bringing down the money supply in the market. A lower money supply would lead to an increase in interest rates.

Now look at the other side. A reduction in CRR would put more money in the coffers of the banks. As the money supply rises, interest rates decrease.

What do we do when interest rates are high?

Well, common sense would dictate that when the interest rates are high, we save, and not spend, money.

On the other hand, lower interest rates act as a disincentive to save money. So, in this case we would spend, and save.

Lower interest rates often boost demand for goods and services. In the short run , this would result in inflation as supply may not be able to match demand. Currently, to control the steeply rising inflation, the RBI twice raised the CRR in the recent past.

I hope you got the idea. The reason why the RBI controls the CRR is that it is an effective and important tool to control inflation.

To put in a nutshell, a higher CRR would mean that there is less money available in the market. So there will be less money with people. This would mean that their demand for goods and services would be low. So the prices would be low.

 

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