CRR and Inflation

For the uninitiated, CRR is Cash Reserve Ratio, the amount of money that a bank must maintain as deposit with the central bank of the country (which is Reserve Bank of India in the case of India), before it can lend out any to individuals or corporations or any other customer.

The observation
Each time the central bank raises the CRR, inflation seemingly goes down.

How much money can banks lend??
Suppose you were to deposit Rs. 100 in the bank tomorrow. And the CRR is 6%. The bank where you deposited your money will keep aside Rs. 6 for the central bank. So it can lend out the remaining Rs. 94. But that's not the end. The banks are further allowed to reason this way: If the borrower of Rs. 94 decides to give out the money to somebody, that somebody may deposit the amount with the bank. So the bank can lend out an extra Rs. 88.36 (Rs. 94 - 6% of Rs. 94). And if the second borrower gives it to another person who brings it back, the banks will obviously have more to lend.

Following the calculation, it can be seen that the amount of money that the bank will be able to lend out is the sum of a geometric progression whose ratio is 0.94 (when the CRR is 6%), and the starting amount is Rs. 100
Rs. 100 + Rs. 94 + Rs. 88.36 + ... = Rs. 100 / (1 - 0.94) = Rs. 1666.67

Or put more plainly, the bank can lend 16.67 times the money you deposit into the bank. And they are legally allowed to think like that. All this time I kept wondering why banks keep getting rich! Also, the point to note that at each amount in the above sum, the bank has a debtor who carries the cost of borrowing and thereby the banks are safe (unless the people start to default on their loans).

Effect of change in CRR to the money supply situation
From above, we can deduce that if the CRR is decreased to say 5% the amount of money that the banks can lend is increased to 20 times. While if the CRR is increased to say 10% the amount of money that the banks can lend is decreased to 10. Thus when the central bank feels that the banks will not be able to handle the credit scenario, that is there is too much money in the system, it will increase the CRR and vice-a-versa. Although the central bank does not do this always. Sometimes it tries to use money market instruments such as treasury bills, bonds, repo rates and reverse repo rates, etc.

Effect of change in CRR on the credit situation (where the inflation part fits in)
Due to this increase in CRR, the ability of banks to lend money goes down. Now banks are also companies and they need to show profit for their business. So keep their profit up, they increase the lending rate which essentially decreases the availability of cheap loans. As the cost of loans go up, you and I tend to spend less on frivolous purchases or at the least try to keep them at the minimum. Thus demand of goods goes down in general. And as you know, the price of a good is driven by demand in a free market economy without price controls. So the prices go down. Consequently inflation goes down.

Effect on Stock Markets

• If there is an increase in CRR, there are chances that the profitability of banks go down. Thus sensing this loss banking stocks may take a hit.
• Parallel to this, the cost of loans that a company may have borrowed would go up. The higher the loan amount, the greater the hit on the bottom line growth of the company. With lesser anticipated profits, people may tend to sell of the stocks of the company with higher debt. This is one reason why corporations tend to prefer equity instead of debt.

Conclusion
The central bank cannot hope to increase the CRR infinitely because with that the consequent demand goes down, which in turn drive the prices into a downward spiral. This obviously leads to lesser profit and eventual losses for companies. To contain this, companies may reduce production, others may go out of business. Only the cash rich companies can afford to sit it out, or invest in newer technologies for more efficient production. In the extreme case, the market would become monopolistic. And you know who loses out in the long run. Keeping all of these factors and effects in the calculation, the central bank needs to decide its policy. No wonder, I don't envy the job of the RBI governor.

You might also want to read these articles from wikipedia:
Fractional Reserve Banking
Quantity Theory of Money
Reserve Requirements