In banking and monetary policy, if the Reserve Bank of India decreases the cash reserve ratio (CRR), what will happen to the volume of credit creation by commercial banks?

Introduction / Context:
The cash reserve ratio, commonly called CRR, is one of the key monetary policy instruments used by the Reserve Bank of India. It specifies the percentage of deposits that commercial banks must keep as cash reserves with the central bank. Changes in CRR directly affect the amount of funds that banks can use to give loans and therefore influence the overall credit creation process in the economy. This question tests basic understanding of how a change in CRR affects bank lending and money supply.

Given Data / Assumptions:
• The Reserve Bank of India decides to reduce the cash reserve ratio. • Banks are required to keep a smaller percentage of their deposits as reserves. • No other policy tool is changed at the same moment. • We focus on the direction of change in credit creation, not on exact numerical values.

Concept / Approach:
Under the fractional reserve banking system, banks keep a fraction of deposits as required reserves and lend out the rest. The money multiplier concept explains how an initial deposit can lead to a multiple expansion of credit. The smaller the reserve ratio, the larger the potential money multiplier, because banks are free to lend out a larger share of each unit of deposits. Therefore, when CRR is reduced, banks experience an increase in loanable funds, which allows them to expand credit and create more deposits in the form of loans.

Step-by-Step Solution:
Step 1: Recall that CRR is the fraction of deposits that banks must hold as reserves with the central bank. Step 2: When CRR decreases, each bank is required to keep a smaller proportion of its deposits idle as reserves. Step 3: This immediately frees additional funds for banks, because a larger share of deposits can now be used for lending and investment. Step 4: When banks lend more, new deposits are created in the system, which further increases the base for additional credit in subsequent rounds. Step 5: Therefore, the overall capacity of the banking system to create credit increases when CRR is reduced.

Verification / Alternative check:
A simple numerical illustration can provide reassurance. Suppose the CRR is 10 per cent. Then for every 100 rupees of deposits, banks must keep 10 as reserves and can lend 90. If the CRR is reduced to 5 per cent, banks must keep only 5 as reserves and can lend 95. Over many rounds of deposit creation and lending, this higher share of lendable funds magnifies total credit in the system. This direct relation between lower CRR and higher lending confirms the answer that credit creation will increase, not decrease.

Why Other Options Are Wrong:
The statement that credit creation will decrease is the opposite of what actually happens, and would correspond to a situation where CRR is increased, not reduced.
The claim that credit creation will remain unchanged ignores the core role of CRR and contradicts the fundamental money multiplier logic of fractional reserve banking.
The idea that credit creation will first decrease and then increase has no standard theoretical support in basic textbook models and is not how CRR is understood in policy discussions.

Common Pitfalls:
Learners sometimes confuse CRR with the statutory liquidity ratio or with policy rates such as the repo rate. They may also reverse the direction of effect, thinking that a reduction in CRR means less security and therefore less lending, which is not how the mechanism operates. Keeping a clear link in mind between lower required reserves, more lendable funds and higher credit creation helps avoid these errors in exam questions and practical discussions about monetary policy.

Final Answer:
When the Reserve Bank of India reduces the cash reserve ratio, the capacity of commercial banks to lend increases, so credit creation will increase.