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