Cash Reserve Ratio is that portion of banks total deposits which Banks have to park with Central Bank (RBI in India). A bank earns its income through lending at higher rates and paying low rate of interest on Deposits.
So any increase in CRR leads to lesser amount of money at disposal of banks, which can be given as advances and loans, thereby sucking liquidity in market. On the other hand, a decrease in CRR implies more money at disposal of banks, and hence more liquidity in market.
Increase in CRR means lesser liquidity, which in turn leads, to higher interest rates, implying fewer new projects, more interest costs for companies and individuals on their outstanding portion of loans (if taken on variable or market linked rate of interest), less spending on luxuries, lesser investments opportunities, etc. this will cause lesser demand and hence prices will come down (i.e. inflation rate will come down).
Thus, an increase in the CRR leads to banks being forced to keep more money with RBI reducing the funds available for lending. As less money is available to the bank to lend there is bias towards increase in rates as per the normal laws of supply and demand. So an increase in CRR will normally result in an increase in interest rates (and vice versa a reduction in CRR will normally result in a reduction in interest rates).
Let us say the RBI increase the CRR. This would mean that banks would have to keep more money with the RBI. This, in turn, would reduce the money available with them, thus bringing down the money supply in the market. A lower money supply would lead to an increase in interest rates.
Over the years CRR has become an important and effective tool for directly regulating the lending capacity of banks and controlling the money supply in the economy. When the RBI feels that the money supply is increasing and causing an upward pressure on inflation, the RBI has the option of increasing the CRR thereby reducing the deposits available with banks to make loans and hence reducing the money supply and inflation.
Now look at the other side. A reduction in CRR would put more money in the coffers of the banks. As the money supply rises, interest rates decrease.
While the availability of Cash Reserves provides numerous benefits to society and the economy, it also poses a serious drawback in the form of lost interest. Banks do not earn interest on cash reserves, which results in reduced earnings for the bank and for its customers. In a 1992 release, the Federal Reserve estimated this loss to exceed $700 million per year in pre-tax earnings, which represents a loss of roughly 2 percent.
What do we do when interest rates are high?
Well, common sense would dictate that when the interest rates are high, we save, and not spend, money.
On the other hand, lower interest rates act as a disincentive to save money. So, in this case we would spend, and save.
Lower interest rates often boost demand for goods and services. In the short run, this would result in inflation as supply may not be able to match demand. Currently, to control the steeply rising inflation, the RBI twice raised the CRR in the recent past.
The reason why the RBI controls the CRR is that it is an effective and important tool to control inflation.
To put in a nutshell, a higher CRR would mean that there is less money available in the market. So there will be less money with people. This would mean that their demand for goods and services would be low. So the prices would be low.
Let’s make the entire concept, more Understandable, citing an example from routine life.
When you deposit Rupees 100, in a Bank, it gets Rupees 100 & now it can use this Rs 100, to lend others, but they have to put some part of it (as per CRR: say it to be 8%), with RBI, i.e. Rupees 8 with RBI, in this case & they are left with Rs 92, to lend to others.
From the perspective of a borrower
As a prospective borrower, you are the worst hit. The cost of money i.e. interest rates will rise post the CRR hike. You will probably need to settle in for a lower loan amount given the EMI. If you are an existing borrower, as long as the rate of interest on your loan is fixed, you are immune to any rise in interest rates. However, if you have a floating rate loan, then expect either the tenure of the loan or the EMI to jump soon.