Cash Reserve Ratio

Most countries across the world have machines in place to ensure that small economic factors don't go out of control. The cash reserve ratio is one such machinery.

What is Cash Reserve Ratio?

It is a machinery aimed at attacking two financial parameters: inflation and prudent liability management.

Basically, a it is a percentage of the liability of a bank, as set by the central bank of a country to be kept aside unused or with the central bank. To put it simply, the central bank usually says that X% of your liabilities will be either entrusted to the central bank or will remain unused in the coffers of the bank. But either way, that X% is not available to the bank for lending. So, you can keep it with the central bank or keep it lying in your own vaults, but you cannot lend it.

The initial aim of the CRR (Cash Reserve Ratio) is presumably to appease the customers and lenders of banks and give them a small guarantee that their money will not be caught between the bank and a defaulting debtor to the bank. Suppose you are a customer of the bank, having kept a substantial amount of money in your account with them. Now, if the bank haphazardly lends your hard-earned money, in the form of loans, to people who don't pay it back, there is a fear that you may lose this money. So, by keeping the ratio, banks set aside a little fund for unforeseen financial trouble.

The second, more well-documented aim of the CRR is to curb inflation. By limiting the amount of money which the banks can lend to the people, the cash in the hands of people available for spending is reduced. As a result, the spending is reduced. In turn, the demand is reduced. And a little bit of economics will tell you, when the supply exceeds the demand, there is a fall in the price of goods.

Of course the CRR can be used both ways. Imagine a situation of economic slowdown, marked by falling prices, severely reduced demand and signs of an economic recession on the horizon. By reducing the percentage of money kept as CRR, the banks are free to lend more money. This now works in the opposite sense, as people who have more money will spend more and spending more will help increase demand. Hence by stimulating demand, the economy can be expected to rise again. Of course, once the target for growth has been met, the CRR rate can once again be brought to the original level.

From the point of view of the banks who keep a part of their cash reserves parked with the central bank of the country, they earn a rate of interest on this money from the central bank. The funds are treated as a bank account kept with the central bank and earn interest at a rate defined by the central bank.

To sum up, it is correct to say that the cash reserve ratio is an important component of the monetary policy set by the government. Its proper use can help improve economic problems in the country, especially the ones related to inflation and economic slowdown. Of course, the ratio is not the defining factor by itself. It is just one of them!