The Hindu Business Line : Money multiplier falls on CRR hikes

Till December 8, when it announced a first round of CRR increase, the RBI's anti-inflationary strategy essentially revolved around controlling the growth of its `own' base money. But this strategy had its limits

New Delhi March 11 The Reserve Bank of India's move to hike the cash reserve ratio (CRR) requirement for banks by a full percentage point of their net deposits since December is beginning to impact money supply in the economy.

The money multiplier or the ratio of broad money (M3) to reserve money (RM), which had steadily risen from 4.33 in 2000-01 to 4.76 in 2005-06 before peaking at 4.93 on November 10, has since fallen to 4.69 for the latest week ended February 16.

How it works

In plain-speak, RM is the base money created by the RBI whenever it mops up foreign exchange from the market or lends to the Government and banks against purchase of securities.

This primary rupee liquidity gets incorporated into the system either as currency with the public or as additional cash with banks.

The surplus cash (over and above their reserve requirement) is lent out by banks to the public, who, in turn, retain a part of this in currency and deposit the rest with banks, which gets further lent and re-deposited, and so on.

The end-result is that every unit of `base' money generates multiple units of `broad money' through successive rounds of deposit-cum-credit creation; it is the latter (M3) that represents the effective liquidity or purchasing power available in the system.

Till December 8, when it announced a first round of CRR increase, the RBI's anti-inflationary strategy essentially revolved around controlling the growth of its `own' base money.

Towards this purpose, it resorted to tightening lending to the Government and banks, besides `sterilising' foreign exchange inflows through offloading of securities under the market stabilisation scheme (MSS).

Demand for funds

But this strategy had its limits. For, so large was the demand for funds that any attempt to control RM growth was offset by an increase in the money multiplier.

Thus, the same base money ended up circulating more number of times to cater to the broad money requirement of a resurgent economy.

What the CRR hikes have done is to force banks to keep a higher share of their deposits as cash reserve that cannot be lent.

To the extent this additional money does not go out to borrowers and gets successively re-deposited or re-lent, it weakens the money multiplier.

The fact that the multiplier has come down from a peak of 4.93 on November 10 to 4.69 on February 16 indicates that this is already happening.

Had the multiplier remained at 4.93, there would have been an extra Rs 1,58,000 crore of liquidity floating in the system. And given that the second round of CRR hike has taken effect only from February 17, a further reduction in the money multiplier can be expected in the coming weeks.

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Money multiplier falls on CRR hikes