Harmonised CRR… What you need to know [Part 1]

If you are reading this, I’m sure you already heard the news about the CRR thingy… CRR just really means Cash Reserve Ratio. It is an apparatus of the CBN to regulate banks so that they don’t just lend out all our deposits. The reason for that is because it is believed that banks should be profitable and should manage a cash flow that will readily accommodate our withdrawals. The truth is, not all bank customers want to withdraw all their deposits at the same time. However, the CBN uses the CRR to regulate how much of our deposits that commercial banks can lend out. The second, and perhaps, more important reason for the CRR is to regulate the money supply in the economy to control, inflation or deflation as the case may be. The good question right now is, “what is Money supply?”

Money Supply is the supply of money in an economy. It is as basic as that. Therefore, the total amount of money in circulation in a given economy is the money supply in that economy. For Nigeria, in broad terms, it’s a little above 19 trillion. The tricky part of this Money Supply stuff is that it is not all cash [i.e. printed notes and coins]. I am sure you are wondering how that can be.

Imagine a small economy with about three banks. Then one Mr. A has NGN 1000 which is all the money in that economy and Mr. A deposits the sum of NGN 1000 to Bank X. The Money supply in that economy is NGN 1000.  After Mr. A left, Mr. B walks in to borrow money from the bank to buy a farm. According to the government of that economy [CBN], CRR is 10%. So Bank X can only lend out 90% of all savings deposits in their vaults so they can’t lend more that NGN 900 to Mr. B. The assumption here is that All that Bank X has is Mr. A’s deposit of NGN 1000. Right, so let’s assume that Mr. B wanted to borrow just NGN 500 from Bank X and Bank X agrees to lend the sum, with a collateral of course, to Mr. B. Then Mr. B walks away with the NGN 500. By this analysis, the money supply in the economy is…? You got it! NGN 1500. Tricky aint it? If you just asked, “why?” the answer is that Mr. A has NGN 1000 in his account. What the bank does with it is none of his business. All that concerns Mr. A is whenever he needs his cash, he walks into his bank and get his reimbursement to the tune of his withdrawal as long as he is not exceeding his minimum balance, if there is one.

I got your next question. What if just after Mr. B left with NGN 500 and Mr. A walks back in to request a sum of NGN 501 or more? Simple. Bank X approaches other banks or the CBN of that economy to lend it money to meet that withdrawal. Now consider a situation when Mr. B decides to buy the farm from Mrs. C and Mrs. C decides as well to put the cash in savings with Bank Y. Then Mrs. D approaches Bank Y to borrow money to fund a project. Let’s assume she borrowed NGN 100. The Money supply is now NGN 1600. Simple!  Therefore, from simple logic it is clear that the higher the CRR, the less the money supply and vice-versa because lower CRR means banks have more money to put in circulation and higher CRR means banks have less.

If you are wondering why this is important, here it is. Milton Friedman, an economist Nobel Laureate (you can google him) came up with a discovery that the more the money supply, the more the inflation, ceteris paribus (of course this is the discovery in a really simple term) and vice-versa. Since that time, Central Banks around the globe are strategically poised to regulate the inflationary or deflationary tendencies in an economy. For more information on Inflation and stuff, check out my post on Money and Prices.

PS; I missed you as well. 🙂