Central Bank is the apex authority to regulate, supervise and control the flow of money in the system. By using monetary policy instruments like SLR, bank rates, cash reserve ratio and repo rates, central bank controls the money supply and inflation in the given economic system. Let’s see in detail the difference between cash reserve ratio and repo rates and impacts on system as whole.
Understanding Central Bank monetary policy instruments
In India Reserve Bank of India, in US the Federal Reserve Bank, in UK Bank of England, etc. are assigned powers and responsibilities to ensure equilibrium in the economic system in terms of liquidity or money supply.
Adequate money supply means neither over supply nor too low is indispensable for smooth functioning of economic system in any nation.
Impacts of too much money supply
In case, if there is too much money supply, it may cause prices of commodities skyrocket resulting inflation and hyperinflation. In such situation, people may face difficulties in maintaining living standards with declined purchasing power.
Shortage of liquidity or money
On the other side, if there is shortage of supply of money, it may cause shortfall of investment for business activities. And, as a result, it may precipitate high unemployment, rise in poverty and decline in living standards. So policy instruments, especially cash reserve ratio and repo rates have strong bearing on the economic growth and living standards of citizens.
Summary of key points of cash reserve ratio and repo rates
- First, Central Banks have powers and responsibilities to interfere in the system of money supply by the means of monetary policy instruments.
- Second, SLR, bank rates, cash reserve ratio and repo rates are major policy instruments used to alter the rate of money supply.
- Third, In case of over supply of money may cause inflation and hyperinflation. Or, shortage of liquidity or money supply may result in unemployment and decline in living standards.
- Fourth, Federal Reserve Bank, Bank of England, Reserve Bank of India etc.are examples of central banks that play the role in money supply in respective countries.
Cash reserve ratio
- First, Cash reserve ratio and repo rates are most important policy instruments in the hands of central banks.
- Second, Cash reserve ratio is the certain portion of cash or cash equivalents of bank that need to be deposited or kept with central bank.
- Third, It is essential because in case of any issue like if the bank becomes bankrupt or anything, central bank takes care of account holders.
- Fourth, Nowadays, cash reserve ratio is 4 percent in India. And, it gets changed as per the observation of central bank or Reserve Bank of India.
Repo rates and reverse repo rates
- First, Commercial banks purchase government securities. In case of need for funds, they can ask for loans from central bank against government securities.
- Second, Central Bank grants loan on such requests at a certain interest rates that is termed as repo rates.
- Third, But, when central bank demands fund or loans from commercial banks, it takes such loan by offering certain interest to commercial banks is called reverse repo rates.
What is SLR and Bank rates
Statutory liquidity ratio is the percentage banks overall capital or cash that bank need to deposit with central bank or invest in gold or government securities as per policy results.
It is done by central bank to reduce the cash or fund with banks. Because, central bank doesn’t want to let the banks to offer more loans.
Simply put, to control the flow of money in system, central bank exercise this instruments. In India, SLR is 18%.
Bank rates and repo rates
Bank rates means the rates at which central banks grant loans to commercial banks without repurchasing agreement. There is repurchasing agreement in case of repo rates.
So, if there is rise in bank rates, it is bound to become loan more costly for commercial banks. As a result, commercial banks raise theirs rates as well accordingly.
Short summary of SLR and Bank rates
- First, SLR is a policy instruments in hands of central banks.
- Second, SLR is a certain amount of capital or cash of commercial banks that is compulsory to deposit or invest in gold or government securities.
- Third, SLR reduces the fund with commercial banks to lend if the rates rises. Or, commercial banks get surplus fund in case of reduction in rates.
- Fourth, rise in bank rates raises the interest rates on loans commercial banks offer to customers and vice-versa.
Difference between cash reserve ratio and repo rates
Here, cash reserve ratio is all about to reserve certain amount of capital or cash that of commercial banks with themselves or with central banks.
Motive is to safeguard the account holders interests in case of bank runs out of cash or become bankrupt. So, Cash reserve ratio doesn’t mean to affect money supply directly but it indirectly affect the amount of cash with banks.
Technically, if the central bank raises the cash reserve ratio, it affects the lending capabilities of commercial banks to customers. And, if the rates go down, opposite will happen.
But, repo rates affect the rate of interest at which commercial banks get loans from central bank against government securities. Or, commercial banks get interest on the fund they deposit with central bank on demand. This is the major difference between cash reserve ratio and repo rates.
Impacts of cash reserve ratio and repo rates
Really, both cash reserve ratio and repo rates are highly impactful policy instruments in hands of central banks. First of all, let’s see the impacts of repo and reverse repo rates on system of money supply.
Impacts of Repo rates rates
Initially, if the commercial banks need money, they demand from central bank or Reserve Bank of India. But, it is demanded against the government securities that commercial banks bought earlier from central banks.
Here, we must understand the repurchasing agreement between commercial banks and central banks. Commercial banks sell government securities on condition that they will repurchase when they are able to do.
Impacts on commercial banks and customers
But, what happens, if the repo rates goes up as per the policy decision, the repurchasing rate also goes up. Hence, the fund with commercial banks become expensive. Consequently, central banks offer loans to customers at higher interest rates.
Finally, customers hesitate to take loans at higher interest rates. So the results in the lesser money in the system.
On the other side, in case of decline in the repo rate, reduces the interest rate commercial banks charge on loans of customers. Therefore, it causes the increase in money supply in economic system.
Impacts of reverse repo rates on lending capabilities
As I mentioned before that reverse repo is rate at which central bank or Reserve Bank of India borrows fund from commercial banks by the means of government securities.
Generally, in case of requirement or anything part of policy, central bank demand fund from commercial banks. RBI or central bank borrow funds at certain interest rate termed as reverse repo.
Suppose, if the central bank raises the reverse repo rate, commercial banks prefer to park or deposit fund with central bank against government securities.
In such case, commercial banks lose theirs lending capabilities to the customers as they prefer safe higher return. Eventually, lesser liquidity results in the system.
Impacts of cash reserve ratio
For layman’s terms, cash reserve ratio is all about the certain fund at hold from commercial banks. It is to safeguard the interests of account holders in case of crisis.
Understandably, rise and fall in the cash reserve ratio affect the lending capabilities of commercial banks. As these banks either to increase deposit as per policy or to release more in case of decrease in CRR.
In both cases, it affects the degree of money supply in the system. And, so will be the impacts on the economic activities. This is about the impacts of cash reserve ratio and repo rates on lending capabilities of commercial banks and economic system as whole.
Final thought on cash reserve ratio and repo rates
So far, I have discussed in detail about the difference between cash reserve ratio and repo rates. Expectedly, every central bank in the world exercise assigned powers and carry responsibilities to control money supply as per demands. For this to make happen, RBI or central banks have certain policy instruments.
Preciously, cash reserve ratio is a means to affect lending capabilities of commercial banks with rise and fall in rates. Whereas, repo rate and reverse repo rate causes both increase or decrease the lending capabilities as well as interest rates.
In case of repo rate, it affects the interest rates of loans commercial banks lends to customers. And, reverse repo rates impacts the lending capabilities as banks either park more or less fund with central banks.
I hope my article on difference between cash reserve ratio and repo rates would help you in your preparation. If you have any questions or queries regarding this article, feel free to ask.
Solved question on cash reserve ratio and repo rates
For easy learning, here are some important questions designed to help students grasp subject matter quickly.
Q. 1. What does central bank mean?
And: Central Bank of any nation is the Apex monetary authority. It is assigned the powers to regulate supervise and control money supply. It also puts checks and balances on inflation as well. Reserve Bank of India, Federal Reserve Bank of US, Bank of England are examples of central banks.
Q. 2. What is monetary policy?
Ans: Monetary policy is a well thought action plan by central banks by using tools or policy instruments like SLR, CRR, Bank rates, and repo rates. It is intended to increase employment and check inflation by regulating money supply in the system. As of now, there are two types of monetary policies. One is expansionary and other is contradictory. Usually, monetary policy committee meets four times in a year to decide policy instruments and interest rates.
Q. 3. What are the policy instruments of central banks?
Ans: Generally, all the central banks in the world have following policy instruments in their hands to control money supply. These are:
- Statutory liquidity ratio or SLR
- Cash reserve ratio or CRR
- Repo rate and reverse repo rate
- Bank rates.
Q. 4. Define cash reserve ratio.
Ans: Cash reserve ratio or CRR is the percentage of capital or cash that bank needs to park with themselves or with central bank. It is done in order to safeguard the interests of account holders in case of any issue or crisis.
Q. 5. Clarify difference between repo and reverse repo rate?
Ans: When commercial banks demand fund from central bank against government securities by repurchasing agreement, central bank gives loan against at a rate called Repo rates. Whereas, central bank gives interest to commercial banks on theirs deposited money with central bank is termed as reverse repo rate.
Q. 6. How do cash reserve ratio and repo rates affect money supply?
Ans: Both cash reserve ratio and repo rates have strong bearing on the rate of money supply. Cash reserve ratio affects the lending capabilities of commercial banks by making more or less funds to deposit with central bank. And, Repo rates do so by making fund more expensive or cheap and affecting the return on funds commercial banks once deposited.
Q. 7. What role does SLR play in money supply?
Ans: SLR or statutory liquidity ratio is all about the specific portion of cash that commercial banks possess. Such portion of cash or gold and government securities need to deposit with central bank. As a result, it decrease or increase the lending capabilities of commercial banks to customers.
Q. 8. How SLR is different from bank rates?
Ans: SLR is a parked fund of commercial banks with central bank in order to control the flow of money supply. And, bank rate is a rate at which central bank lends to the commercial banks.
One affect available fund with commercial banks. And, other makes loans expensive or cheaper.