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Explain, Using a Numerical Example, How a Reduction in Reserve Deposit Ratio, Affects the Credit Creation Power of the Banking System. - Economics

Answer in Brief

Answer the following question.
Explain, using a numerical example, how a reduction in reserve deposit ratio, affects the credit creation power of the banking system.

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Solution

Reserve Deposit Ratio or Cash Reserve Ratio refers to the minimum proportion of the total deposits that the commercial banks have to maintain with the central bank in the form of reserves. An increase in this ratio would mean that banks would be required to keep a greater portion in the form of deposits with the central bank. This implies that commercial banks are left with a lesser amount of funds to lend out. Hence, the lending capacity of the banks reduces, leading to a fall in the money supply. On the contrary, a fall in CRR will lead to an increase in the money supply.

To summarise,
CRR ↑ ⇒ Deposits with the bank's ↓ ⇒ cash reserves of the bank ↓ ⇒ Lending capacity of the bank's ↓ ⇒ Money supply ↓ 

CRR ↓ ⇒ Deposits with the bank's ↑ ⇒ cash reserves of the bank ↑ ⇒ Lending capacity of the bank's ↑ ⇒ Money supply ↑

A depositor deposits Rs.10,000 in his savings account, which will become the demand deposit of the bank. Based on the assumption that not all customers will turn up at the same day to withdraw their deposits, the bank maintains a minimum cash reserve of 10 % of the demand deposits, i.e. Rs.1000. It lends the remaining amount of Rs.9000 in the form of a credit to other customers. This further creates deposits for the bank XYZ of Rs 9000. Now in the next round, out of Rs 9000, Rs 900 goes as cash reserves and the remaining Rs 8100 are extended as loans. And so the process will continue. Such a process will increase the money supply in the economy by the amount (times) of credit multiplier. Suppose the reserve deposit ratio or cash reserve ratio is equal to 10%. Then:

Credit multiplier = `1/"CRR" = 1/10` % = 10

Therefore, the money supply will increase by 10 times and the total credit created in the economy will be equal to around Rs 1,00,000.

The process can be supported by the following table:

Rounds Deposits Received
A
Loans Extended
B
Cash Reserves
Initial 10,000 9000 1000
Round I 9000 8100 900
Round II 8100 7290 810
Round III - - -
Round IV - - -
- - - -
- - - -
Round N - - -
Total 1,00,000 90,000 10,000

Now suppose the CRR reduces to 5%. Then:

Credit multiplier = `1/"CRR" = 1/5` % = 20

Therefore, the money supply will increase by 20 times and the total credit created in the economy will be equal to around Rs 2,00,000.

Rounds Deposits Received
A
Loans Extended
B
Cash Reserves
Initial 10,000 9,500 500
Round I 9,500 9,025 475
Round II 9,025 8753.75 451.25
Round III - - -
Round IV - - -
- - - -
- - - -
Round N - - -
Total 2,00,000 1,90,000 10,000

With the fall in Reserve Deposit Ratio or CRR, the money supply increases in the economy.

Concept: Money Creation Or Credit Creation by the Commercial Banking System
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