If the Reserve Bank of India (RBI) reduces the cash reserve ratio (CRR) that commercial banks must maintain, what will be the most likely impact on the overall process of credit creation in the banking system?

Introduction / Context:
This question deals with an important tool of monetary policy used by the Reserve Bank of India (RBI): the cash reserve ratio (CRR). The CRR specifies the percentage of their deposits that commercial banks must keep as cash reserves with the RBI. Understanding how changes in CRR affect banks ability to create credit is fundamental for topics related to money supply, monetary policy, and banking operations in the Indian economy.

Given Data / Assumptions:

• CRR is the fraction of deposits that banks must maintain as cash reserves with the RBI.
• The RBI is assumed to reduce the CRR.
• Commercial banks continue to follow the fractional reserve system.
• We assume that banks are willing and able to lend additional funds when they have excess reserves.
• Other policy tools and economic conditions are considered unchanged for the purpose of this question.

Concept / Approach:
Under the fractional reserve banking system, commercial banks keep only a fraction of deposits as reserves and lend out the rest, which leads to multiple expansion of deposits and credit. The cash reserve ratio determines the minimum portion that must be held as reserves with the RBI. When the RBI reduces the CRR, banks are required to keep a smaller fraction of their deposits as reserves. This frees up more funds that can be used for lending and investment, thereby increasing the capacity of the banking system to create credit. Conversely, an increase in CRR would absorb liquidity and reduce credit creation.

Step-by-Step Solution:
Step 1: Recognise that CRR is a mandatory reserve requirement. A lower CRR means banks can hold fewer funds idle with the RBI.Step 2: When CRR is reduced, a portion of the funds that were previously locked as reserves is released back to the banks as excess reserves.Step 3: Banks can use these excess reserves to extend new loans or purchase securities, which increases their interest earning assets.Step 4: Through the credit multiplier process, each new loan leads to multiple rounds of deposits and further lending, expanding overall credit in the economy.Step 5: Therefore, a reduction in CRR increases the credit creation capacity of the banking system.Step 6: The correct description of this effect is that credit creation will increase.

Verification / Alternative check:
We can verify the effect using the simple money multiplier formula in a fractional reserve system. If the required reserve ratio (rr) falls, the theoretical money multiplier, which is 1 / rr, becomes larger. For example, if CRR falls from 4 per cent to 3 per cent, the multiplier increases from 25 to about 33.33. This means that the same initial injection of reserves now supports a larger expansion of deposits and credit. This numerical reasoning confirms that lower CRR is expansionary for credit and money supply.

Why Other Options Are Wrong:
It will decrease credit creation: This would be true if the RBI increased the CRR, not when it reduces the ratio.

It will have no impact on credit creation: Changes in CRR are specifically used as a tool to influence liquidity and credit, so there is definitely an impact.

The impact on credit creation will be uncertain and indefinite: While actual lending depends on many factors, the basic direction of the effect of a CRR cut is clear and expansionary.

It will completely stop credit creation by banks: This is the opposite of what happens; credit creation becomes easier, not impossible.

Common Pitfalls:
Students sometimes confuse CRR with other measures like statutory liquidity ratio (SLR) or open market operations and may incorrectly assume that any policy change tightens credit. A simple way to remember the effect is that a lower required reserve ratio frees more money for lending and therefore increases the scope for credit creation, while a higher ratio locks up more funds with the central bank and restricts lending.

Final Answer:
If the RBI reduces the cash reserve ratio, the credit creation capacity of banks will increase.