Demonetization in India: Impact on the Economy

On November 8, 2016, the government of India took away the legal tender character of 500 and 1000

Rupee denomination of banknotes. As a result, 86 percent of the currency (nearly 11 percent of GDP) in circulation was reduced suddenly from the economy. The shortage of currency created a shock to the economy which has several implications. Of course, the capacity to spend by the people had affected directly reducing the consumption demand in the domestic economy. The unorganised sector operates substantially outside the formal banking channels and uses cash for its transactions. The unorganised sector affected badly sinking their production. This affects demand in the entire economy since. As this sector still produces 45 percent of the national output, it has significant contractionary effect in the economy.The rate of growth of the economy as a whole would come down.

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Demonetization reduces the cash in the economy. But, cash in the Indian economy represents only less than one fourth of total money supply. While the Reserve Bank of India supplies the cash circulating in the economy, the banking system as a whole creates more money by lending the deposits it gets to others. While the amount of currency in circulation sharply declines, the deposits with the banks increases although slowly. The money multiplier, the ratio of money in the economy to the cash that the central bank releases in the economy, rises as the people uses less and less of cash and more and more of the deposits with the banks. Cash held by the people is a leakage from the banking system and not available to be further circulated.

New Delhi: People queue up at out side of banks ATM to get money in New Delhi on Sunday. PTI photo by Vijay Verma

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It is argued that there are agents in the economy who are hoarding currency as a method for storing savings, especially by people earning unaccounted or illegal incomes. Demonetization has been introduced for reining in the unaccounted incomes or wealth in the economy. It is being argued that the part of wealth held by people as cash would be extinguished as a result of demonetization. There is artificial suppression of demand because of the cash crunch. After remonetisation with the new series of bank notes, consumption demand has started to rise, and if the items are in short supply because of the contraction in economic activity or because of supply chain management, inflation may go up.

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Mr. Panchanan Das
Professor of Economics,
University of Kolkata
Kolkata, West Bengal, India