Question

Assuming for a hypothetical economy, Central Bank increases the Reserve Ratio from 20% to 25%, and the total primary deposits stand at ₹ 1,000.

Explain the effect of rise in Reserve Ratio on credit creation by commercial banks.

Answer 1

The Central Bank requires banks to retain a portion of their deposits in reserve, known as the Cash Reserve Ratio (CRR). Increasing the reserve ratio reduces bank lending, affecting credit growth. In the made-up economy, increasing the reserve ratio from 20% to 25% affects credit growth:

Initial Situation:

• Total Primary Deposits: ₹ 1,000
• Initial Reserve Ratio: 20%
• Reserves to be Held: 20% of ₹ 1,000 = 200
• Amount Available for Lending: ₹ 1,000 − ₹ 200 = ₹ 800

After an increase in the Reserve Ratio:

• New Reserve Ratio: 25%
• New Reserves to be Held: 25% of ₹ 1,000 = ₹ 250
• Amount Available for Lending: ₹ 1,000 − ₹ 250 = ₹ 750

Effect on Credit Creation:

1. Reduction in Lendable Funds: To meet the new 25% reserve ratio, banks must hold a larger share of their deposits as reserves. This lowers the loanable amount from ₹ 800 to ₹ 750.
2. Decrease in the Money Multiplier: Banks have less money to lend, so the money multiplier declines. To find the money multiplier, take the reserve ratio and invert it. At first, the money ratio was `1/0.20`, which equals 5. It’s now `1/0.25` = 4 after the rise.
3. Lower Credit Creation: By lowering the money multiplier, the banking system can’t make as much credit altogether. Thus, the total amount of money that can be made by loans is smaller than it used to be.
4. Impact on Economic Activity: As businesses and individuals have less access to loans, slower credit growth can lead to lower spending and investment. Slower economic growth may result from this.

The power of commercial banks to create credit is limited when the reserve ratio goes from 20% to 25%. Due to fewer loans available for investment and spending, this drop in credit creation can slow down the economy.