What is CRR?
Cash Reserve Ratio (CRR) is a percentage of deposits that banks must hold as cash reserves either with themselves or with the central bank.
For example if the CRR is 6% and a customers have deposited $100 with a bank, the bank should in turn hold cash reserves of $6. While most banks are allowed to keep this money as cash reserves, it is usually deposited with the central bank.
How is CRR used by central banks?
CRR is used as a monetary tool to contain inflation. When the central bank sees a situation of rampant inflation it raises the CRR to contain it. In effect raising the CRR means reducing the amount of money that a bank will have to lend out and thus decreasing money supply in the market.
This works out more potently than most of us imagine.
Imagine a situation where you deposit $100 in a bank, if the CRR is 10% then the bank can lend $90 to me and then I deposit $90, out of which 81 can be lent again, in the next round this will be 90% of 81 viz. 72.90 and so on and so forth. The total sum of all this is $900. So with $100 initial deposit and 10% CRR, the money supply created in the economy is $900.
Now if in the same situation the CRR is 20%, out of the initial $100 only $80 can be lent now and $64 in the next round and so on and so forth till the total lending is $400.
So a doubling of CRR leads to more than halving the money supply creation in the economy. That is why central banks raise the CRR whenever they face rising inflation.
When does raising CRR not work?
While CRR is a potent tool, it is not free from criticism. World over economists tend to think that open market operations which means that the central bank just goes out in the open market and buys up currency there is equally effective, if not more.
Raising CRR means that the banks raise the rate of interest at which they lend out funds to investors, so basically that translates into slowing down lending and economic activity and overall can translate into lower GDP growths.