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Difficulty: EasyMonetary Policy Framework, RBI Mechanisms, Banking System, and Financial Markets

When the Reserve Bank of India (RBI) increases the Cash Reserve Ratio (CRR) applicable to commercial banks, what is the immediate impact on the liquidity available in the banking system?

  1. Liquidity in the banking system decreases.Answer
  2. B
    Liquidity in the banking system increases.
  3. C
    Liquidity in the banking system remains completely unaffected.
  4. D
    Commercial banks immediately increase their credit creation capacity.

Answer

Liquidity in the banking system decreases.
The Cash Reserve Ratio (CRR) is a quantitative monetary policy tool specifying the fraction of total deposits commercial banks must maintain as balance with the Reserve Bank of India. Raising the CRR obligates banks to lock away a larger portion of their funds, directly decreasing their loanable reserves and reducing liquidity in the economy.

Step-by-Step Solution

1
Recall the definition of Cash Reserve Ratio (CRR).
CRR is the mandatory percentage of Net Demand and Time Liabilities (NDTL) that commercial banks must hold as cash reserves with the RBI.
Understanding the function of CRR is necessary to evaluate its impact on bank reserves.
2
Analyze the operational effect of raising the CRR.
A higher CRR obligates banks to transfer a larger share of customer deposits into RBI reserve accounts.
This directly reduces the volume of loanable cash remaining with commercial banks.
3
Determine the resulting change in banking system liquidity.
With fewer lendable resources in the banking sector, liquidity decreases across the economy.
Contracting the amount of money banks can lend absorbs excess money supply from the system.

Key Concept

Cash Reserve Ratio (CRR) and Bank Liquidity Transmission
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Topics

Monetary Policy Framework, RBI Mechanisms, Banking System, and Financial Markets