Question

Briefly explain how Cash Reserve Ratio can be used to control credit.

Explain how CRR can be used by the central bank to control credit.

Answer 1

The portion of a commercial bank's total deposits that it must hold with the reserve bank in the form of cash reserves is referred to as the CRR. As a result, all scheduled banks are obligated to keep a set percentage of their total deposits with the reserve bank (determined by the reserve bank's CRR). By altering this reserve ratio, the reserve bank hopes to affect commercial banks' credit creation power and so regulate the country's credit ratio. Credit contraction occurs when the CRR is raised, while credit growth occurs when the CRR is reduced.

Answer 2

Cash reserve ratio is a direct, quick and effective method of controlling the power of commercial banks to create credit. Cash reserve ratio is the minimum percentage of the total deposits with the commercial banks which they are required to maintain in the form of cash reserves with the central bank. Commercial banks are required by law to keep a certain percentage of their deposits with the central bank in the form of cash reserves. This is known as the statutory minimum reserve, and the excess over this statutory minimum reserve is the excess reserve. It is on the basis of these excess reserves that commercial banks are able to create credit. The central bank has the power to vary the statutory minimum reserve ratio. An increase in the cash reserve ratio (CRR) means that commercial banks are required to keep more cash with the central bank. Consequently, the size of the excess cash reserve with the commercial banks is reduced, and their capacity to create credit is squeezed. Therefore, the commercial banks will be in a position to create only a smaller volume of credit. Likewise, a fall in the cash reserve ratio (CRR) will enable the commercial banks to expand their credit because banks will have more cash balance with them as they are required to keep less cash with the central bank.