Question

Assuming for a hypothetical economy, the 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.

Hint:

An increase in the Reserve Ratio decreases the credit multiplier and limits the capacity of commercial banks to create credit.

Answer 1

The Reserve Ratio, also known as the Cash Reserve Ratio (CRR), is the fraction of the total deposits that commercial banks are required to keep as reserves with the central bank. When the central bank increases the Reserve Ratio from 20% to 25%, it reduces the amount of money available for banks to lend out. This limits the credit creation capacity of commercial banks. To explain this effect, let's calculate the credit multiplier and the potential credit creation:
1. Initial Reserve Ratio (20%): - Reserve Ratio = 20% - Total Primary Deposits = ₹1,000 - Required Reserve = 20% of ₹1,000 = ₹200 - The rest, ₹800, is available for lending. Using the credit multiplier formula: \[ \text{Credit Multiplier} = \frac{1}{\text{Reserve Ratio}} = \frac{1}{0.20} = 5 \] So, the total credit creation potential = ₹800 5 = ₹4,000. 
2. New Reserve Ratio (25%): - Reserve Ratio = 25% - Total Primary Deposits = ₹1,000 - Required Reserve = 25% of ₹1,000 = ₹250 - The rest, ₹750, is available for lending. New Credit Multiplier = \(\frac{1}{0.25} = 4\) 
So, the total credit creation potential = ₹750 4 = ₹3,000. By increasing the Reserve Ratio, the central bank reduces the amount of money available for lending, thus decreasing the total credit creation in the economy. 
The total credit creation potential drops from ₹4,000 to ₹3,000.