Cash reserve ratio – Effect on interest rate?

Cash reserve ratio – Effect of Cash Reserve Ration on interest rate. For better understanding of CRR we will first understand:

What does CRR mean?

The purpose served by CRR.

Then, the effect of CRR on interest rates.

• Cash reserve ratio (CRR) like the name suggests is the ratio of cash that bank needs to keep reserved with the central bank. CRR can also be defined as the proportion of deposits that banks need keep with the Reserve Bank of India (RBI) in cash fortnightly. Presently the CRR is 6% that is, for every Rs100 deposited in the bank; bank will need to deposit Rs6 with RBI. Or in other words, banks can’t lend or use this Rs6 for any purpose. This does not mean that the remaining Rs94 can be used by the banks for lending as other than CRR they have to meet other predetermined proportion of the deposits as directed by RBI. Also banks don’t earn any interest on the funds deposited (as CRR) with RBI.
• The main purpose of CRR is to protect the risk of the bank’s depositors to an extent and to ensure that a bank maintains some funds in liquid form.

The other purpose it serves is, it helps to adjust liquidity in the system, the supply of money circulating in the economy. When there is excess money supply in the market, RBI will increase the CRR to drain out the excess. Inversely if the economy is falling short of liquidity, then RBI will decrease the CRR to release more funds in the market. This is thus one of the instruments that the central bank uses to control inflation.

• When the CRR is increased, the amount of funds that a bank can lend decreases. Banks then try to encourage more deposits by increasing the interest rates. Rising interest rate usually discourage loan seekers as a higher interest rate means that the cost of money has increased.

CRR is only one of the factors that influence interest rates. Change in CRR has a major effect on the bank though it may not have a major effect on investors unless other factors also influence interest rates.