Wednesday, April 30, 2008

Effects of CRR hike on Inflation seen through money multiplying effect

The Reserve Bank of India, on 29th April 2008, increased the Cash Reserve Ratio (CRR) by 25 basis points (0.25%) to 8.25% as a policy measure to curb inflation in the country.

Cash Reserve Ratio sets the minimum reserve money banks must hold to deposits they own. A CRR of 8.25% means banks have to keep 8.25% of the total deposits they have with them as a cash reserve and shall not lend it to others or use it for any other purposes. In earlier periods this reserve was meant to protect depositor money in case a bank went bankrupt. But nowadays CRR is used as an effective tool in monetary policy to control interest rates and borrowing and is also used by developing countries like India and China to control inflation.

One of the main reasons of inflation is the money supply in the economy. When people have more money in their hands, they tend to pay more for goods and services (Supply vs. Demand) thereby increasing their prices. When CRR is increased, banks will have to keep more money as reserve restricting them to lend that much money into the economy. A CRR hike of 0.25% means Rs. 9000 Crore of extra money has to be kept as reserves, which means that that much money will be taken out from circulating in the economy and from being avaiable in the hands of people for spending. As a result people tend to pay less, making prices of goods and services (or inflation) come down.

This has more implications than what it appears prima facie. Money usually has a multiplier effect. Suppose a bank has Rs. 100 in deposits, with a CRR of 8.25%, it has to keep Rs. 8.25 with them and remaining Rs. 91.75 they can lend to borrowers. The borrower then gives the money to someone (through payment or lending) and the person who receives it (or if the person who receives it gives it to someone else and so on, then the last person who receives it) would deposit it in another bank. The second bank will keep 8.25% of the deposit of Rs. 91.75 and lend Rs. 84.18 to some other borrower. And the cycle continues.

In this way money available with a bank will in turn be available for various other banks for lending, due to the multiplier effect of money described above. Hence money taken away from the banking system through CRR hike will have a much higher effect, as the percolation will cause multiple increase in the overall cash reserve.

Thus higher reserve requirement results in reduced money creation in the economy and is accentuated by the multiplying effect of money. Hence increasing CRR is a highly effective method to reduce money supply in the economy; there by reducing inflation.


Avinash said...

Excellent article dude!
Helped clear the concept thoroughly.

Prof. Prasad Joshi said...


Its really simple to understand...