Commercial banks hold reserves of Rs 300 and keep no extra reserves. There is no currency with the public. The RBI raises the Cash Reserve Ratio from 20 per cent to 25 per cent. Which of the following is correct?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Money supply falls from Rs 1,500 to Rs 1,200, and banks reduce their loans by Rs 300.
Given:
Reserves = Rs 300
No currency with the public, so money supply = deposits
CRR rises from 20 per cent (0.2) to 25 per cent (0.25)
The relation is deposits = reserves × money multiplier, where money multiplier = 1 / CRR.
At a CRR of 20 per cent:
\( \displaystyle \text{Money multiplier} = \frac{1}{0.2} = 5 \)
\( \text{Deposits} = 300 \times 5 = \text{Rs } 1{,}500 \)
\( \text{Loans} = 1{,}500 - 300 = \text{Rs } 1{,}200 \)
At a CRR of 25 per cent:
\( \displaystyle \text{Money multiplier} = \frac{1}{0.25} = 4 \)
\( \text{Deposits} = 300 \times 4 = \text{Rs } 1{,}200 \)
\( \text{Loans} = 1{,}200 - 300 = \text{Rs } 900 \)
Loans fall from Rs 1,200 to Rs 900, by Rs 300.
Rs 75 is only the extra reserve the old deposits would need. Banks cannot add reserves, so they call back loans instead.
NCERT (2026-27): “3.3.2 Limits to Credit Creation and Money Multiplier … Since the bank is only expected to keep 20 per cent of its deposits as reserves, thus, reserves of Rs 100 (20per cent of 500 = 100) can support the deposits of Rs 500. In other words, our bank can give a loan of Rs 400. Table 3.3 demonstrates its balance sheet.
“3.4 Policy Tools to Control Money Supply … It should be evident by now that if the Central bank changes the reserve ratio, this would lead to changes in lending by the banks which, in turn, would impact the deposits and hence, the money supply. … But the banking system would now be able to loan Rs 300 only. It would have to call back some loans to meet the increased reserve requirements. Hence, money supply would fall. …” |
