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Demonetisation: 1978, the Present and the Aftermath

J Dennis Rajakumar ( is Director and S L Shetty ( is Advisor, EPW Research Foundation, Mumbai.

In the context of the demonetisation of ₹500 and ₹1,000 notes, the issuance of currency and its different denominations are traced over time, while also tracking key macroeconomic features of India's changing economy over the decades. Further, the possible immediate and longer term economic effects of demonetisation are discussed.

It is now widely acknowledged that the public at large is suffering due to the 8 November announcement to demonetise the ₹500 and ₹1,000 notes. An overwhelming proportion of the population has been directly punished by this decision that aims to tackle the black economy. Such extreme steps are resorted to only in response to situations of hyperinflation or some form of financial crisis. No such situation exists now.

India’s previous experience with demonetisation was when the then President of India promulgated the High Denomination Bank Notes (Demonetisation) Ordinance on 16 January 1978, demonetising the ₹1,000, ₹5,000 and ₹10,000 currency notes with the objective of eliminating “the possible use of such notes for financing illegal transactions” (RBI 1977–78: 77). At that time, demonetisation received limited public attention and had little impact on the daily lives of people. High denomination notes demonetised then, formed just a minuscule fraction—about 0.6%—of the total currency in circulation (Table 1, p 14). Further, the demonetised notes were of significantly high value, having little use for common people. The current situation is different, the demonetised ₹500 and ₹1,000 notes constitute over 85% of total notes in circulation by value.

The authorities, in 1978, seemed to have been prompted to act against the holdings of high denomination notes due to quantum jumps in such currency holdings in 1975–76 and 1976–77 (Table 1). After the 1978 demonetisation, ₹100 notes remained the highest denomination in circulation for about a decade. In October 1987, the Reserve Bank India (RBI) issued ₹500 banknotes, apparently with a view to meeting higher transaction needs arising from inflation. Later, the ₹1,000 note was reintroduced in November 2000.

There is another aspect of the 1978 experience that needs to be noted. A large portion—45% of the high denomination notes in circulation or about 53% of the high denomination notes tendered for conversion—were with banks and government treasuries and not with the public (Table 2, p 14). This time, however, only ₹96,080 crore or just about 5% of the total notes in circulation were with banks and government treasuries. In the first week of November 2016, when the current demonetisation took place, about 95% of such currencies were with the public.1

Another fundamental difference between the 1978 measure and the current one relates to the motivation behind the actions taken. The reason this time, according to the RBI, is that there has been an increased incidence of fake notes in higher denominations, and that these notes are used by terrorists and by those hoarding black money (RBI 2016c).

However, the RBI’s recent annual reports have shown how counterfeit notes detected in the banking system (excluding counterfeit notes seized by the police and other enforcement agencies) have been rising, but not alarmingly. Counterfeit notes have generally constituted less than or around 0.002% of the notes in circulation.2

In accordance with international practice, the process of withdrawal of old notes, of the pre-2005 series in India, began in May 2013, but “in phases to preclude any inconvenience to the public” (RBI 2016a: 92). While such notes remained legal tender, the facility for their exchange remains available only at RBI offices. This was done in a routine manner through banks. Initially, the exchange window was made available till January 2015, with RBI taking utmost care not to cause inconvenience to the public. “Banks were sensitised to ensure the withdrawal in a smooth and non-disruptive manner without causing any inconvenience to the public” (RBI 2014: 108). The exchange facility was however extended till December 2015 “to ensure withdrawal of the remaining pre-2005 old design banknotes with least inconvenience to members of the public” (RBI 2015: 110). The principle of indirect demonetisation is thus achieved through gradual withdrawal of specific older series of notes. This seems to have brought, among other things, some reductions in the detection of counterfeit notes during 2012–13 and 2013–14 (RBI 2014: 109).

Currency Holdings since 2001–02

Phenomenal changes have taken place in the economy during the past decade and a half. There has been considerable diversification in favour of services sector in total gross domestic product (GDP), which obviously absorbs higher amounts of currency. Liberal economic policies included sizeable reductions in marginal tax rates, impetus for trade, easing of controls on foreign direct investment, as also portfolio investment in share markets, liberalisation of commodity trading, and opening up of large numbers of organised retail outlets. All of these have created a liberal economic environment which has given impetus to people to hold large amounts of cash. Over time, due to persistence of inflation, the value of the rupee has also eroded.

In such an environment, the authorities responded by reintroducing high denomination notes for ease of trade and general economic activities. Until the introduction of ₹500 notes in October 1987 and reintroduction of ₹1,000 notes in November 2000, ₹50 and ₹100 notes had held sway (Table 1). In 2000–01 about 65% of the notes in circulation were in the form of ₹50 and ₹100 notes and by 2015–16, their share dwindled to just about 10%. The ₹500 and ₹1,000 notes have increased in share: ₹500 notes from about 25% in 2000–01 to 47% in 2015–16, and ₹1,000 notes which were issued in 2000–01 grew to 38% in 2015–16. Thus, the two together accounted for as much as 86% of the total notes in circulation, which showed that transactions in India have been preponderantly through these two denominations.

Currency and GDP Growth

A comparison of the growth of note issuances with other macroeconomic indicators such as growth rate of GDP at market price and the inflation rate produces interesting results (Table 3).


First, the rate of increase in high denomination notes outpaced the increase of total bank notes throughout the post-independence period. Second, the annual growth rates in total currency as well as those in high denomination notes have been much higher than the nominal GDP growth (which could be partly due to monetisation). For instance, the annual average of high denomination notes growth during the eight-year period from 2005–06 to 2012–13 worked out to 22.2%, which has been much higher than the average annual GDP growth of 15.3% in nominal terms. Even the average growth of total currency issues at 15.8% has been somewhat higher than the average GDP growth. This was as per the 2004–05 series of GDP estimates. According to the 2011–12 GDP series, high denomination notes grew at 12.3% in 2012–13, which was 0.9 times of the GDP growth rate. By 2015–16, high denomination notes grew at 16.5%, surpassing the GDP growth rate of 8.7%, that is, 1.9 times higher. A similar trend is noticed when we compare growth of issue of bank notes to GDP growth rate (Figure 1). Increase in the issue of high denomination notes and total bank notes have taken place in spite of lower order of inflation rate during the last few years. Normally, the impetus for currency expansion comes from high inflation.

High Cash and Demand Deposits

Has the phenomenal rise in the issue of bank notes, particularly high denomination notes, altered the behaviour of money supply in the economy? In India, both narrow (M1) and broad money (M3) concepts are used. M1 consists of currency with the public, demand deposits, and other deposits with the RBI, while M3 additionally includes time deposits. M1 has expanded during the last few years essentially due to sizeable increases in currency with the public, while demand deposits have grown at high rates in some years (Table 4). M3 mostly comprises time deposits, a little over three-fourths, though a marginal reduction is seen during the last two years. Amongst the components of M1, currency with public is the primary one. Although the ratio of currency with public to M3 (also known as currency ratio) has been declining over the years, except in the last two years, demand deposits as a ratio has remained nearly the same. The percentage variation of M1 was higher than that of M3 in recent times due to sluggish growth in time deposits. In the overall expansion of M3, the share of M1 has doubled from 14.4% in 2013–14 to 28.8% in 2015–16, with simultaneous reduction in the share of time deposits. Within M1, the share of currency with the public has gone up from 9.3% to 19.2%, and demand deposits went up from 5.2% to 9.5% between 2013–14 and 2015–16. Thus, the bulk of increase in money supply (that is, liquidity generated) during these years is attributable to the huge rise in currency with the public and demand deposits.

Falling Velocity of Money

The income velocity of money is normally measured as a ratio of nominal GDP to money supply.3 The view that issue of bank notes were done to meet the transaction motive of money can be well examined if we observe a rise in GDP to currency (Table 5). The income velocity of currency has marginally come down from 9.63 in 2004–05 to 9.08 in 2009–10, but this has gone up to 9.32 in 2012–13. This observed trend is based on GDP as per 2004–05 series. Considering GDP 2011–12 series, it is seen that income velocity of currency has marginally risen from 9.02 in 2011–12 to 9.44 in 2013–14, only to decline to 9.21 in 2015–16. A near similar trend is witnessed in the ratio of GDP to demand deposits as well. Overall, the GDP-to-M3 ratio has consistently fallen from 1.26 in 2013–14 to 1.22 in 2015–16. In view of a larger rise in the money supply relative to GDP growth, the income velocity has declined. Reduction in income velocity has also occurred at a time when the inflation rate has been slowing. But the behavioural change demonstrated by the velocity has been largely explained by income velocity of currency and demand deposits.

Does the increased use of currency reflect the failure of electronic payments to expand? As per RBI data, retail electronic payments as a percentage of nominal GDP have risen only nominally; it fell from 127.5% in 2013–14 to 123.4% in 2014–15 and then increased to 130.9% in 2015–16.4 It thus explains the persistence of relatively higher growth in bank notes and high denomination notes in the last two years. We may attribute this to the public’s propensity to treat money also as a store of value, apart from being a medium of exchange. What is more, these are years in which inflation rate was lower than earlier years and hence the public would have viewed minimum erosion in the value of money, which in turn would have increased their propensity to view currency as a store of value. That alone does not justify demonetisation unless such currency holdings are largely illegal or have large unaccounted sources.

Expected Outcomes

Whether demonetisation this time will achieve its stated purpose can be understood only when more statistics become available. The extent of demonetised high denomination currency that finally fails to be exchanged for new notes or be deposited in banks will be an important indicator.

Economic consequences of the demonetisation measure have many dimensions. Short-term can be further divided into two parts: disruptions in the lives and day-to-day activities of people, and the shock leading to contractions in consumption, trading and household incomes. Savings are unlikely to be affected as currency holdings will be converted into bank deposits, though no doubt such actions will have medium-term implications, particularly on interest rates.

The tremors that demonetisation has sent across the economy were clearly visible in the course of last many days with trading activities crumbling. One may treat this as a shock. But this has to be absorbed to prevent it from precipitating further crisis. The shock absorbers include stepping up private and public investment, and global demand for domestically produced goods.

The interest rates are expected to go down due to a surfeit of liquidity in the banking system with the public depositing high denomination notes and withdrawing only limited amounts. This is very unlikely to boost private investment as firms anyway would have excess capacity. Global demand cannot be expected to drive domestic production and employment as the global economy still trails. Demand for imported goods can go down due to depressed price situation and want of liquidity in the market. This can make the dollar cheaper (or rupee stronger) which will further weaken export competitiveness (unless of course the demand for the dollar increases due to other reasons).

Based on the prediction of money market equilibrium models, we know that any inward shift in the money supply curve (which demonetisation can easily do) will put pressure on the interest rate, if there is no discernible shift in the money demand curve. Due to the inconvenience caused and for want of currency for transaction purposes, the money demand curve could shift downward, thus leaving interest rates unaffected, but having adverse effects on the level of output. In other words, withdrawal of high denomination notes will certainly have a short-term impact on market transactions and hence output level in the economy. That is, aggregate demand in the economy gets adversely impacted in the short run, which perforce implies that the price level in the economy would go down in the next few months (if reflation is not a public policy choice). If aggregate demand falls due to reduction in money supply with a simultaneous fall in prices, inventories will build up, which firms may not want due to the opportunity costs involved, and this can eventually impact production. Adjustments in outsourcing firms, and small and medium enterprises would be exposed to a higher order of demand risk affecting employment in that segment. Thus, the short-term impact could have far-reaching consequences. Conceding to this line of reasoning would mean that the recent demonetisation has clearly set a stage for an economic crisis that is sure to affect the economy unless public spending increases.

Increasing public spending is perhaps doable in the current scenario. Currency notes issued are liabilities of the RBI, and to the extent demonetised notes do not get surrendered, the liabilities of RBI could be expected to go down unless these liabilities are not extinguished.5 If such liabilities are extinguished, the most likely result would be a corresponding addition to RBI’s accrued income as part of “other liabilities and provisions” on the liabilities side to begin with. As per practice and statute, such surplus income eventually becomes part of the annual transfer to the central government. Hence, it could augment the government’s revenue. Given this expected improvement in the fiscal position arising from demonetisation, public spending may be viewed as the sole shock absorber.

Public Policy and Public Pain

Studies on corruption practices in India have shown that the system of bribes, underhand dealings and use of dubious means to get things done, are rampant. These practices, it cannot be denied, are all pervasive. The abundant supply of ₹2,000 notes, a poorly thought-out move, will gravitate towards those interested in unaccounted transactions, once again encouraging illegal transactions.

The malaise of unaccounted transaction ought to have been addressed at its root, that is, by closely examining high value transactions to uncover their sources of financing; for instance by raiding real estate and jewellery sector operators. It is not for nothing that a study by the World Bank staff has placed India at the top of emerging market economies as moving the highest share of shadow economy in total GDP (22.2%) as compared with China’s 12.7% and Japan’s 11%.6 Further, there is a need to monitor conspicuously high levels of expenditure in India and even abroad, on marriages and other such extravaganzas. Besides, if any administration is sincere about attacking the phenomenon of unaccounted money, it has to strictly regulate political party funding. When all these fairly straightforward alternatives exist, the government machinery did not have to inflict such hardships on the public.


1 This is evident from the fact that total currencieswith banks and government treasuries were worth above ₹96,080 crore, while the high denomination notes in circulation alone in March 2016 were of the order of ₹14,17,940 crore. Total non-public holdings of all currencies were then only 6.4% of high denomination currencies in circulation.

2 Authors’ estimates based on data extracted from Table VIII.8 of RBI Annual Report 2015–16 (p 92).

3 This follows from the simple quantity theory of money which is expressed as M*V = P*Q; where M is the total money supply, V is the velocity of money, P is the price level and Q is the output. In fact, P*Q is the monetary value of goods and services produced in the economy, represented by GDP. The income velocity (V) can be worked out by rearranging this equation as P*Q/M.

4 Authors’ estimates based on data extracted from Table IX.I of RBI Annual Report 2015-16 (p 95).

5 The RBI’s publications including relevant RBI history volume (RBI 2005: 450–53) make no reference to the treatment of those high denomination currency notes not tendered then for exchange. A sense that we get after a careful scrutiny of RBI’s Annual Reports for 1978–79 and 1979–80, and Report on Currency and Finance 1977–78, 1978–79, 1979–80 and 1980–81, is that, under the demonetisation of 1978, those notes which were not tendered for exchange were very likely not extinguished from RBI’s balance sheet and continued to remain with the public as “notes in circulation” (public including banks and government treasuries).

6 This is the country average for the period from 1999 to 2007. See Schneider et al (2010: 27–30).


Reserve Bank of India (1977–78): Report on Currency and Finance 1977–78, Mumbai: RBI.

— (1978): Annual Report 1977–78, Mumbai: RBI.

— (2005): History of the Reserve Bank of India (1967–1981), Volume 3, Mumbai: RBI.

— (2014): Annual Report 2013–14, Mumbai: RBI.

— (2015): Annual Report 2014–15, Mumbai: RBI.

— (2016a): Annual Report 2015–16, Mumbai: RBI.

— (2016b): Handbook of Statistics on Indian Economy 2015-16, Mumbai: RBI.

— (2016c): Frequently Asked Questions Withdrawal of Legal Tender Character of the Existing Bank Notes in the Denominations of 500 and 1,000 (Updated as on 18 November 2016), accessed at the, on 21 November 2016.

Schneider, F, A Buehn and C E Montenegro (2010): “Shadow Economies All over the World New Estimates for 162 Countries from 1999 to 2007,” Policy Research Working Paper 5356. Washington DC: World Bank.


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