Cash Reserve Ratio
The Cash Reserve Ratio is the amount of funds that the banks are bound to keep with Reserve bank of India as a portion of their Net Demand and Time Liabilities (NDTL). The objective of CRR is to ensure the liquidity and solvency of the Banks. The CRR is maintained fortnightly average basis.
Impacts of Reducing CRR
When CRR is reduced, more funds are available to banks for deploying in other businesses because they need to keep fewer amounts with RBI. This means that the banks would have more money to play and this leads to reduction of interest rates on Loans provided by the Banks.
In context with inflation, reduction in CRR leaves more money in the hands of commercial banks and this leads to increase in the money supply in system. When money supply increases, too much money chases too few goods and this leads to rise in inflation.
Impacts of Increasing CRR
When RBI increases the CRR, less funds are available with banks as they have to keep larger protions of their cash in hand with RBI. This means that banks will now have less money to play with. Moreover, Reserve Bank does not pay any interest on the CRR balances. Since commercial banks don’t earn any interest, the banks are left with an option than to increase the interest rates. If RBI hikes this rate substantially, banks will have to increase the loan interest rates. The home loans, car loans and EMI of floating Rate loans increase. Thus hike in CRR leads to increase of interest rates on Loans provided by the Banks.
Reduction in CRR sucks money out of the system causing to decrease in money supply. When money supply decreases, the inflation comes down.
Ceiling on CRR
Please note that earlier RBI was empowered to fix RBI between 3-20% by notification. However, from 2006 onwards the RBI is empowered to fix the CRR on its discretion without any ceiling.
Do banks earn interest on CRR?
They used to do once upon a time. From March 31, 2007 onwards, RBI does not pay any interest on the CRR balances maintained by Scheduled Commercial Banks.