What is 'Demonetization'
Demonetization is the act of stripping a currency unit of its status as legal tender. It
occurs whenever there is a change of national currency: The current form or forms of
money is pulled from circulation and retired, often to be replaced with new notes or
coins. Sometimes, a country completely replaces the old currency with new currency.
The opposite of demonetization is remonetization, in which a form of payment is
restored as legal tender.
What are the impacts of
Demonetisation on Indian Economy?
tojo jose
November 16, 2016
Demonetization is a generations’ memorable experience and is going to be
one of the economic events of our time. Its impact is felt by every Indian
citizen. Demonetization affects the economy through the liquidity side. Its
effect will be a telling one because nearly 86% of currency value in
circulation was withdrawn without replacing bulk of it. As a result of the
withdrawal of Rs 500 and Rs 1000 notes, there occurred huge gap in the
currency composition as after Rs 100; Rs 2000 is the only denomination.
Absence of intermediate denominations like Rs 500 and Rs 1000 will
reduce the utility of Rs 2000. Effectively, this will make Rs 2000 less
useful as a transaction currency though it can be a store value
denomination.
Demonetization technically is a liquidity shock; a sudden stop in terms of
currency availability. It creates a situation where lack of currencies jams
consumption, investment, production, employment etc. In this context, the
exercise may produce following short term/long term/,
consumption/investment, welfare/growth impacts on Indian economy. The
intensity of demonetization effects clearly depends upon the duration of
the liquidity shocks. Following are the main impacts.
1. Demonetization is not a big disaster like global banking sector crisis of 2007; but
at the same time, it will act as a liquidity shock that disturbs economic activities.
2. Liquidity crunch (short term effect): liquidity shock means people are not
able to get sufficient volume of popular denom ination especially Rs 500. This
currency unit is the favourable denomination in daily life. It constituted to nearly
49% of the previous currency supply in terms of value. Higher the time required
to resupply Rs 500 notes, higher will be the duration of t he liquidity crunch.
Current reports indicate that all security printing press can print only 2000
million units of RS 500 notes by the end of this year. Nearly 16000 mn Rs 500
notes were in circulation as on end March 2016. Some portion of this were fill ed
by the new Rs 2000 notes. Towards end of March approximately 10000 mn units
will be printed and replaced. All these indicate that currency crunch will be in
our economy for the next four months.
3. Welfare loss for the currency using population: Most active segments of
the population who constitute the ‘base of the pyramid’ uses currency to meet
their transactions. The daily wage earners, other labourers, small traders etc.
who reside out of the formal economy uses cash frequently. These sections will
lose income in the absence of liquid cash. Cash stringency will compel firms to
reduce labour cost and thus reduces income to the poor working class.
There will be a trickle up effect of the liquidity chaos to the higher income
people with time.
4. Consumption will be hit: When liquidity shortage strikes, it is
consumption that is going to be adversely affected first.
Consumption ↓→ Production ↓→ Employment ↓→ Growth ↓→ Tax revenue
↓
5. Loss of Growth momentum– India risks its position of being the
fastest growing largest economy: reduced consumption, income,
investment etc. may reduce India’s GDP growth as the liquidity impact
itself may last three -four months.
6. Impact on bank deposits and interest rate: Deposit in the short
term may rise, but in the long term, its effect will come down. The savings
with the banks are actually liquid cash people stored. It is difficult to
assume that such ready cash once stored in their hands will be put into
savings for a long term. They saved this money into banks just to convert
the old notes into new notes. These are not voluntary savings aimed to get
interest. It will be converted into active liquidity by the savers when full -
fledged new currency supply take place. This means that new savings wit h
banks is only transitory or short-term deposit. It may be encashed by the
savers at the appropriate time. It is not necessary that demonetization will
produce big savings in the banking system in the medium term. Most of
the savings are obtained by biggie public sector banks like the SBI. They
may reduce interest rate in the short/medium term. But they can’t follow it
in the long term.
7. Impact on black money: Only a small portion of black money is
actually stored in the form of cash. Usually, black inc ome is kept in the
form of physical assets like gold, land, buildings etc. Hence the amount of
black money countered by demonetization depend upon the amount of
black money held in the form of cash and it will be smaller than expected.
But more than anything else, demonetization has a big propaganda effect.
People are now much convinced about the need to fight black income.
such a nationwide awareness and urge will encourage government to come
out with even strong measures.
8. Impact on counterfeit currency: the real impact will be on
counterfeit/fake currency as its circulation will be checked after this
exercise.
Demonetization as a cleaning exercise may produce several good things in
the economy. At the same time, it creates unavoidable income and welfa re
losses to the poor sections of the society who gets income based on their
daily work and those who doesn’t have the digital transaction culture.
Overall economic activies will be dampened in the short term. But the
unmeasurable benefits of having more transparency and reduced volume of
black money activities can be pointed as long term benefits.