Most countries across the world have mechanisms in place to ensure that economic factors don't go out of control. The cash reserve ratio is one such machinery aimed at attacking two financial parameters - inflation and liability management.
Cash Reserve Ratio (CRR) is a specified minimum percentage of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. It is set according to the guidelines of the central bank of a country.
To put it simply, the central bank usually says that X% of a bank's liabilities will either be entrusted to the central bank or will remain unused in the coffers of the bank. But either way, that X% will not be available to the bank for lending. This is a vital economic parameter for every bank.
Why is it Important?
The initial aim of the CRR is presumably to appease the bank customers and give them a guarantee that their money will not be caught between the bank and a defaulting debtor. Suppose you are a customer of the bank, having kept a substantial amount of money in your account with them.
Now, if the bank haphazardly lends your hard-earned money, in the form of loans, to people who don't pay it back, there is a fear that you may lose this money. So, by keeping this ratio, banks set aside a small fund for unforeseen financial trouble.
The second, more well-documented aim of the CRR is to curb inflation. By limiting the amount of money which the banks can lend, cash available for spending in the hands of the people is reduced. This, in turn, leads to a fall in demand. When the supply exceeds the demand, there is a fall in the price of goods.
Of course, this monetary policy can be used in both ways. Imagine a situation of economic slowdown, marked by falling prices, severely reduced demand, and signs of an economic recession on the horizon. By reducing the percentage of deposits kept as CRR, the banks are free to lend more money.
This works in increasing public consumption, thereby uplifting the economy. Once the target for growth has been met, the CRR can be brought to the original level. From the point of view of the banks, who keep a part of their cash reserves parked with the central bank, they earn interest on this money.