Question

How does the Central Bank control credit creation in the economy through cash reserve ratio? Explain.

Answer 1

Dear Student,
Cash reserve ratio is a direct, quick and effective method of controlling the power of commercial banks to create credit. Cash reserve ratio is the minimum percentage of the total deposits with the commercial bank which they are required to maintain in the form of cash reserves with the central bank. Commercial banks are required by law to keep a certain percentage of their deposits with the central bank in the form of cash reserves. This is known as the statutory minimum reserve and the excess over this statutory minimum reserve is the excess reserve. It is on the basis of this excess reserves that commercial banks are able to create credit. The central bank has the power to vary the statutory minimum reserve ratio. An increase in the reserve ratio means that commercial banks are required to keep more cash with the central bank. Consequently the size of the excess reserves with the commercial banks is reduced and the capacity to create credit is squeezed therefore the commercial banks will be in a position to create only a smaller volume of credit. Similarly, a fall in the reserve ratio will enable the commercial banks to expand their credit because banks will have more cash balance with them as they are required to keep less cash with the central bank.Thus, by changing the reserve ratio that the commercial banks are required to keep with the RBI in the form of cash against their deposits the RBI can influence the credit creation power of the commercial banks.
Regards