Fresh Deposit, Credit Multiplier and a Fixed Pension
A district central cooperative bank in Balasore has just received ₹50 crore as a fresh deposit from a state government agency. The bank must keep 4 per cent of its net demand and time liabilities as cash reserve ratio with the Reserve Bank, and it chooses to hold no excess reserves; it lends the rest, and borrowers spend the money in the same district, where it comes back as deposits to the same banking system. At a press meet the chairman boasts that the deposit will create ₹1,250 crore of new deposits in the district and revive the local economy. Meanwhile, the district's consumer price index has risen 8 per cent over the year, while a retired schoolteacher's pension has stayed fixed at ₹12,000 a month. The Monetary Policy Committee has called headline inflation 'above target' and is expected to tighten policy, even though the bank's own lending has grown 18 per cent.
1. Check the chairman's arithmetic using the money multiplier, and show what would happen to deposit creation if the cash reserve ratio were raised to 5 per cent. State the assumptions on which your answer rests.
Read the worked answer
The multiplier. Money multiplier = 1 ÷ reserve ratio = 1 ÷ 0.04 = 25. Total deposits created = initial deposit × multiplier = 50 × 25 = ₹1,250 crore, so the chairman's figure is arithmetically correct in the textbook model. New credit = 1,250 − 50 = ₹1,200 crore (the original ₹50 crore is the reserve base, not new credit).
The process: the bank keeps 4% (₹2 crore) and lends ₹48 crore; the borrowers' spending returns as deposits; 4% of that is kept and ₹46.08 crore lent; and so on until the total reaches ₹1,250 crore.
If CRR rises to 5%: multiplier = 1 ÷ 0.05 = 20; total deposits = 50 × 20 = ₹1,000 crore; new credit = ₹950 crore. A one-percentage-point rise in CRR destroys ₹250 crore of potential deposits.
Assumptions: no currency held by the public, no excess reserves, every borrower willing to borrow, and all spending staying inside the district's banking system. In reality, cash leakages, weak loan demand in a slow season, and spending on goods from outside the district all shrink the multiplier, so ₹1,250 crore is a ceiling, not a forecast. Deposits are also liabilities of the bank, not income for the district.
2. Calculate the real value of the retired teacher's pension. Who gains and who loses from an 8 per cent inflation rate, and what should the pension be if it were fully indexed?
Read the worked answer
Real value = nominal ÷ price index (as a decimal) = 12,000 ÷ 1.08 = ₹11,111 a month. The teacher loses about ₹889 a month, or roughly ₹10,667 a year, in purchasing power.
Fully indexed pension: 12,000 × 1.08 = ₹12,960 a month; only then does the real pension stay at ₹12,000.
Losers
- People on fixed nominal incomes: pensioners, unrevised salaries without dearness allowance, small depositors.
- Creditors and lenders on fixed interest, if the interest rate is below inflation - e.g. a 5% deposit against 8% inflation gives a real return of (1.05 ÷ 1.08) − 1 ≈ −2.8%.
- Wage earners whose wages are renegotiated only slowly.
Gainers
- Borrowers, including the government and firms with fixed-interest loans, who repay in cheaper rupees.
- Traders and speculators holding stocks of goods whose prices are rising.
- Anyone whose income is indexed (dearness allowance) or whose asset prices rise faster than prices in general.
The redistribution is arbitrary: it does not depend on need or effort but on whether a contract is fixed in nominal terms. The teacher's case is why governments index pensions and why the RBI's inflation target matters to savers.
3. Explain how the Reserve Bank's decision to tighten policy would work through the banking system to reduce inflation, and identify two reasons why it may not succeed quickly.
Read the worked answer
The transmission chain
- The RBI raises the repo rate (and may also raise CRR or sell securities in open market operations).
- Banks' cost of funds rises and, with a higher CRR, fewer rupees can be lent from each deposit - in this case the multiplier falls from 25 to 20, cutting potential deposits from ₹1,250 crore to ₹1,000 crore.
- Credit becomes costlier and scarcer: borrowing for cars, houses, business expansion and working capital slows.
- Investment and consumption spending fall, so aggregate demand grows more slowly than aggregate supply.
- With demand pressure easing, the rate of price increase moderates; expectations of future inflation also soften, which restrains wage and price setting.
Why it may not succeed quickly
- Supply-side inflation: if the district's price rise comes from vegetables, pulses or fuel - food shocks - compressing demand does not increase supply and mainly hurts output.
- Lags and coverage: monetary policy acts after several months, and a large part of rural and small-town credit comes from informal lenders, moneylenders and self-help groups outside the RBI's instruments.
- Other costs: small firms and the cooperative bank's own borrowers (lending already growing 18%) may be squeezed hardest, so the cure can damage growth before it lowers prices.
Hence tightening is usually combined with supply measures - buffer stocks, imports, better storage - and with fiscal restraint so that the two arms of policy do not pull against each other.