"Must Reserve Bank Pay Interest On CRR Balances ?"
There has been passionate demand in some quarters that the Reserve Bank pay interest on the so- called cash reserves maintained with it by banks as part of its monetary policy. The current applicable Cash Reserve Ratio (CRR) is 4% of Net Demand and Time Liabilities (NDTL). But there is no logic and reason to paying interest on CRR because CRR is about impounding liquidity with a view to reducing M3 (Money Supply) through adjustment to reserve money/primary liquidity/high-powered/base money which can universally be created /withdrawn "only" by a central bank ! Typically, under the fractional reserve banking, required reserve ratio (CRR) sets the theoretical maximum limit on broader money banks can create through making loans out of their deposits. Thus, if CRR be 4% of NDTL, as now, then the theoretical maximum M3 is 1/0.04=25 times the required reserves, i.e. the money multiplier (MM) is 25. But in actual practice, public preference to keep a chunk of their deposits in the form of cash/currency and banks choosing to accumulate excess reserves, act as a drain on broad money creation resulting in much smaller actual/empirical/observed money multiplier ! Thus, currently the actually observed money multiplier (MM) is about 6, obtained by dividing the current M3 of about Rs 90 trillion ( currency worth Rs 12 trillion and deposits worth Rs 78 trillion) by Reserve Money of about Rs 15 trillion (currency worth Rs 12 trillion and CRR worth Rs 3 trillion) . It is not that RBI cannot, and should not, pay interest on CRR as demanded in some quarters. Only that to have the desired extent of impounding to influence aggregate demand in the real economy, M3 will still need to be contracted by a certain amount. What will happen if interest is paid is that the effective/ substantive contraction/withdrawal of money will be less to the extent of interest - reserve/ primary/base money - paid by RBI and so CRR will have to be so much higher than, say 4% at present, to achieve the required contraction in M3 (Money Supply) to achieve the required compression in aggregate demand in the real economy ! More generally, if C% be the CRR without interest payment by RBI and i% be interest to be paid by RBI, and C1 be the new/corresponding CRR accruing interest at i%, then interest accrued on C1 will be i/100*C1 and so effective impounding with payment of interest will be (C1-i/100*C1)=C1(1- i/100) which must equal the policy neutral objective/goal of C i.e. C1(1- i/100)=C or , C1= C/ (1-i/100). So, if i= 6.75 % (Current Reverse Repo Rate) and C=4%, as now, then the required CRR C1 with payment of interest will be: C1=4/(1-0.0675)=4/0.9325=4.29% . In other words, the choice is simple: either have monetary impact neutral CRR of 4% without payment of interest, or have CRR at 4.30% with payment of 6.75% interest by RBI!