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Difficulty: MediumCentral Banking Functions and Monetary Policy Tools

To curb rising general price levels, the monetary authority decides to raise the Cash Reserve Ratio (CRR) applicable to deposit money banks. Which of the following represents the immediate operational outcome of this policy adjustment on the commercial banking sector?

  1. A reduction in the margin of excess reserves accessible for bank lendingAnswer
  2. B
    An expansion in the volume of loanable funds available to private sector borrowers
  3. C
    A decrease in the cost of borrowing charged on commercial loan facilities
  4. D
    An increase in the total liquidity available to banks for purchasing government securities

Answer

A reduction in the margin of excess reserves accessible for bank lending
Raising the Cash Reserve Ratio obligates commercial banks to keep a larger proportion of their customer deposits immobilized with the monetary authority. Consequently, the volume of excess reserves available for banks to grant credit to borrowers decreases.

Step-by-Step Solution

1
Identify the policy tool and direction
The instrument is an increase in the Cash Reserve Ratio (CRR), a contractionary monetary policy tool.
An increase in CRR raises the statutory percentage of total deposits that commercial banks must hold with the central bank.
2
Analyze the impact on commercial bank reserves
Required reserves increase, leaving fewer uncommitted funds.
Because a greater portion of total deposits is immobilized to meet statutory requirements, available excess reserves fall.
3
Determine the credit creation outcome
Commercial bank lending capacity drops.
Credit creation relies on excess reserves; shrinking these reserves curtails the ability of deposit money banks to extend new loans.

Key Concept

Cash Reserve Ratio and Credit Contraction
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Topics

Central Banking Functions and Monetary Policy Tools

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