Recently, there has been much discussion on whether the RBI would consider changing its reserve ratio to alter credit availability in the economy. What is reserve ratio and how does it affect money supply in the economy?
It is the minimum amount of deposits and notes that commercial banks are mandated by their respective central bank to set aside as reserves for contingency.
This move is established in view of unanticipated (bulk) withdrawals from customers so that banks are able to (at least partially) meet their repayment obligations.
Thus, if commercial banks receive Rs 1,000 as deposits from customers, they set aside a proportion — say 5 or 10 per cent — of that Rs 1,000, which cannot be lent to borrowers. Only the remaining 95 or 90 per cent of the deposit amount (deposit – RR*deposits) can be loaned out.
In other words, RR serves as a restriction on the amount of money or credit that banks can loan out.
Thus, it is straight forward to understand that low levels of RR will make more money available for banks to lend to borrowers, and vice-versa. But how does this process of loaning out actually create a ripple effect in credit availability?
Relationship between RR and money multiplier
In the example above, let us assume that banks hold Rs 1,000 as deposits, and the RR is fixed at 10 per cent. This implies that banks would be able to loan out Rs 900 as credit to its borrowers, which is basically deposited in the same or another bank.
Of this Rs 900, the bank is mandated to hold 10 per cent as RR. This translates to Rs 90, and thus the remaining Rs 810 can again be loaned out, which again is deposited in another bank.
Again, 10 per cent of Rs 810 (Rs 81) has to be kept as RR and the remaining Rs 729 can be lent out. This cycle keeps on continuing until initial deposit amount Rs 1,000 grows exactly by the multiple of RR (in this case, 10%).
In other words, the expanded credit availability would be 1000 + 900 (90% of 1000) + 810 (90% of 900) + 729 (90% of 810) + (90% of 729) +…
This summation finally would be equivalent to 1/10% of 1000, which is Rs 10,000. Thus, in our example, the initial deposit is capable of multiplying itself out 10 times — this multiple is called the money multiplier, denoted by ‘m’. As a formula, m = 1/RR (in our example, 1/10% = 10).
In practice, though, people hold a combination of both cash and deposits, so the multiplier is slightly more involved than the above. And the related formula would be m = C+D/LC; where, C is cash, D is deposits, and LC is the most liquid and acceptable form of cash. Regardless, the functioning logic remains the same as explained earlier. Multiplier in India currently stands close to six times, as per the RBI releases.