How raises in CRR help RBI in curbing inflation.?

How raises in CRR help RBI in curbing inflation?Explain the phenomenon with the help of incidence from the past where CRR and inflation correlation was proved.

One Reply to “How raises in CRR help RBI in curbing inflation.?”

  1. CRR is CASH RESERVE RATIO : the minimum percentage of Deposits with a bank has to maintain in the form of cash or reserves with Reserve Bank of India(RBI) . This will ensure sufficient amount at the disposal of the bank to cater to the withdrawals by the depositors on demand. Let uis say each bank is required to keep a minimum CRR of 10%. So with as fresh depoist of Rs 100, the bank keeps Rs8 and lends Rs. 90 to potential borrowers by creating fresh deposit of Rs 90. The bank knows that the people who have taken the loans will also not draw more than 10% of the additional deposits of Rs 90. But his cash at the beginning was increased by Rs. 100.due to the first deposit. So he lends further to fresh borroewers till his excess reserves goes down to zero. This happens when he had extended loan equivalnt to Rs 900. Thus in the end yout bank has fresh deposits of Rs 100 plus loan induced deposit of 900 – a total of Rs1000 This is called money multplier = 1/ CRR = 1/.1 =10 in this case.
    If CRR is raised to 20%, then the banks money multiplier reduces to 1/0.2 = 10/2 = 5. sO WITH A HIGHE crr, THE BANK’S MONEY MULTIPLIER GOES DOWN. sO THE BANKS ABILITY TO LEND GOES DOWN. tHIS MERANS LOWER SUPPLY OF MONEY. With lower supply of money, fewer money will be chasing to buy goods and services, This will mean lower inflation.
    When banks lend money to people, new money is created. Rise in CRR reduces the ability to lend amd hence the total money created from the deposits. Lower money supply means lower demand for goods and services and therefore lower price inflation.
    Lower money supply and bank credit also means the banks charge higher interest on loans. The demand for loans goes down. So, first you reduce rate of growth of money supply. That raises interest rates which in turn reduces the demand for money. Thus liquidity in the syastem reduces,. This helps curb further rise in prices. This reduces inflation rate.
    Read RBI for Fed – the mechanism is similar .
    A central bank is a “bankers’ bank.” The customers of the twelve Federal Reserve banks are not ordinary citizens but “banks” in the inclusive sense of all depository institutions—commercial banks, savings banks, savings and loan associations, and credit unions. They are eligible to hold deposits in and borrow from Federal Reserve banks and are subject to the Fed’s reserve requirements and other regulations.
    At year-end 1990, federal debt outstanding was $2,569 billion, of which only 12 percent, or $314 billion, was monetized. That is, the Federal Reserve banks owned $314 billion of claims on the Treasury, against which they had incurred liabilities in currency (Federal Reserve notes) or in deposits convertible into currency on demand. Total currency in public circulation outside banks was $255 billion at year-end 1990. Banks’ reserves—the currency in their vaults plus their deposits in the Fed—were $59 billion. The two together constitute the monetary base (M0), $314 billion at year-end 1990.
    Banks are required to hold reserves at least equal to prescribed percentages of their checkable deposits. Compliance with the requirements is regularly tested, every two weeks for banks accounting for the bulk of deposits. Reserve tests are the fulcrum of monetary policy. Banks need “federal funds” (currency or deposits at Federal Reserve banks) to pass the reserve tests, and the Fed controls the supply. When the Fed buys securities from banks or their depositors with base money, banks acquire reserve balances. Likewise the Fed extinguishes reserve balances by selling Treasury securities. These are open-market operations, the primary modus operandi of monetary policy. These transactions are supervised by the Federal Open Market Committee (FOMC), the Fed’s principal policy-making organ.
    A bank in need of reserves can borrow reserve balances on deposit in the Fed from other banks. Loans are made for one day at a time in the “federal funds” market. Interest rates on these loans are quoted continuously. Central bank open-market operations are interventions in this market. Banks can also borrow from the Federal Reserve banks themselves, at their announced discount rates, in practice the same at all twelve banks. The setting of the discount rate is another instrument of central bank policy. Nowadays it is secondary to open-market operations, and the Fed generally keeps the discount rate close to the federal funds market rate. However, announcing a new discount rate is often a convenient way to send a message to the money markets. In addition to its responsibilities for macroeconomic stabilization, the central bank has a traditional safety-net role in temporarily assisting individual banks and in preventing or stemming systemic panics as “lender of last resort.”
    2.The reserve requirement (or required reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands, and would normally be in the form of fiat currency stored in a bank vault (vault cash), or with a central bank.
    The reserve ratio is sometimes used as a tool in monetary policy, influencing the country’s economy, borrowing, and interest rates.] Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves; they prefer to use open market operations to implement their monetary policy. The People’s Bank of China does use changes in reserve requirements as an inflation-fighting tool,[2] and raised the reserve requirement nine times in 2007. As of 2006 the required reserve ratio in the United States was 10% on transaction deposits (component of money supply “M1”), and zero on time deposits and all other deposits.
    An institution that holds reserves in excess of the required amount is said to hold excess reserves.
    Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 cash deposit can lend up to $90 of that deposit, keeping only a $10 cash deposit within the bank. If the borrower then writes a check to someone who deposited the $90, the bank receiving that deposit can lend out $81. As this fractional-reserve banking process continues, the banks can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+…=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+…=$500). Thus, higher reserve requirements should result in reduced creation of transaction deposits.
    Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits such as CDs, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.
    3.Saturday March 31, 07:34 AM
    India’s central bank ordered commercial banks to hold a larger share of deposits in cash, and raised a key short-term lending rate in a bid to curb high inflation that has stoked fears of overheating.
    The Reserve Bank of India increased the cash reserve ratio _ the proportion of deposits that commercial banks must hold in cash _ to 6.5 percent from 6 percent. The hike will take effect in two installments of a quarter of a percent each, from April 14 and April 18, an RBI statement said Friday.
    The RBI also increased the repurchase rate, the rate at which it lends to commercial banks in the short term, by a quarter point to 7.75 percent. The announcement came hours after the government released data showing inflation remained unchanged at a near two-year high of 6.5 percent in the week ended March 17.
    India’s brisk economic expansion _ the economy is growing close to 9 percent for the second straight year _ has boosted middle-class incomes, but it is also driving up prices with too much money chasing fewer goods. The spike in inflation has triggered concerns that the economy might be overheating and could be headed for a hard landing unless inflation is contained.
    “In the light of the current macroeconomic, monetary and anticipated liquidity conditions, and with a view to containing inflation expectations, it is critical to take demonstrable and determined action on an urgent basis,” the RBI statement said.
    The hike in the cash reserve ratio is the third since December and is expected to suck out 155 billion rupees (US$3.5 billion; €2.6 billion) from the banking system. The hike in the repurchase rate is the sixth since January 2006.
    The successive rate hikes and monetary tightening will likely slow economic growth in the coming months.
    Earlier this week, the Asian Development Bank said it expects growth of India’s economy to slow to 8 percent in the next fiscal year starting in April.
    Friday’s announcement by RBI is expected to spark another round of increase in mortgage and other lending rates by commercial banks, which, in turn, will slow credit growth and dampen investment.
    “The stance of monetary policy has progressively shifted from an equal emphasis on price stability along with growth to one of reinforcing price stability with immediate monetary measures and to take recourse to all possible measures promptly in response to evolving circumstances,” the RBI said. The current inflation rate is significantly higher that RBI’s projection of a 5.0 percent to 5.5 percent for the current fiscal year ending March 31.

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