Bank Reserves and a Budget Deficit
A scheduled commercial bank has total deposits of ₹800 crore, cash reserves of ₹72 crore, and loans and advances of ₹700 crore. The RBI’s cash reserve ratio is 8%. A large exporter deposits ₹40 crore with the bank. The bank’s manager wants to lend as much as possible, but the RBI is worried about inflation and announces a rise in CRR to 10%. In the same week, the finance ministry releases budget figures: revenue receipts ₹6,000 crore, capital receipts ₹2,500 crore, revenue expenditure ₹7,500 crore, capital expenditure ₹3,000 crore, and interest payments ₹1,200 crore. A newspaper editorial says the government should cut capital expenditure to reduce the fiscal deficit, because “all deficits are bad.” The bank manager and an economics student are asked to analyse both the credit and budget numbers.
1. Calculate the bank’s initial excess reserves and the money multiplier at CRR 8%. After the ₹40 crore deposit, how much new lending is possible if the bank keeps no excess reserves? Then calculate the effect of a 10% CRR.
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At CRR 8%:
- Required reserves on ₹800 crore = 0.08 × 800 = ₹64 crore
- Excess reserves = 72 − 64 = ₹8 crore
- Money multiplier = 1/0.08 = 12.5
After the ₹40 crore deposit, deposits = ₹840 crore and reserves = 72 + 40 = ₹112 crore. Required reserves = 0.08 × 840 = ₹67.2 crore. Excess reserves = 112 − 67.2 = ₹44.8 crore. If the bank keeps no excess reserves, it can lend up to ₹44.8 crore. The theoretical credit creation potential of the banking system is 44.8 × 12.5 = ₹560 crore.
At CRR 10%: Required reserves = 0.10 × 840 = ₹84 crore. Excess reserves = 112 − 84 = ₹28 crore. Money multiplier = 1/0.10 = 10. Potential credit creation = 28 × 10 = ₹280 crore. The CRR hike reduces both excess reserves and the multiplier, so credit creation falls from a potential ₹560 crore to ₹280 crore.
2. Compute the revenue deficit, fiscal deficit and primary deficit from the budget data. Interpret each.
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Revenue deficit = revenue expenditure − revenue receipts = 7,500 − 6,000 = ₹1,500 crore.
Fiscal deficit = total expenditure − total receipts excluding borrowings = (7,500 + 3,000) − (6,000 + 2,500) = 10,500 − 8,500 = ₹2,000 crore. Equivalently, fiscal deficit = revenue deficit + capital expenditure − capital receipts = 1,500 + 3,000 − 2,500 = ₹2,000 crore.
Primary deficit = fiscal deficit − interest payments = 2,000 − 1,200 = ₹800 crore.
Interpretation: the government must borrow ₹2,000 crore. A revenue deficit of ₹1,500 crore means borrowing is partly financing current consumption rather than asset creation, which is a fiscal weakness. The primary deficit of ₹800 crore shows the current year’s borrowing requirement excluding the burden of past debt interest; ₹1,200 crore of the fiscal deficit is simply interest on earlier borrowing.
3. Evaluate the editorial’s advice to cut capital expenditure. Use the deficit numbers and the distinction between revenue and capital expenditure.
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Cutting capital expenditure would reduce the fiscal deficit mechanically: every ₹1 cut in capex reduces the deficit by ₹1. But capital expenditure creates schools, roads, hospitals and other assets that support future growth and tax revenue. Since the revenue deficit is ₹1,500 crore, the government is already borrowing for current spending. Cutting capex while leaving the revenue deficit untouched would worsen the asset position and may reduce future growth.
A better judgement is to reduce low-priority revenue expenditure, improve tax compliance, target subsidies and use capital receipts to finance productive capital expenditure. Borrowing for capex can be justified if the return on the asset exceeds the interest cost. The editorial’s claim that “all deficits are bad” is too simplistic: the composition of the deficit matters, not only its size.