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Economic Consequences of Demonetisation

Money Supply and Economic Structure

Arun Kumar ( is a former professor of economics, Jawaharlal Nehru University, New Delhi.

The nature of money supply and its link with transactions in the economy are discussed, with necessary modifications on account of the presence of the unorganised sector and the black economy. This helps incorporate differentiation in the Indian economy that is useful to understand and analyse the impact of demonetisation.

Demonetisation, announced on 8 November 2016, has resulted in the withdrawal of the high denomination currency notes of ₹1,000 and ₹500 as legal tender. These are being slowly replaced by new currency. This has suddenly created a shortage of currency which has implications for the economy. The issue is whether the effects visible are short-term or long-term. Those who support the decision argue that there would be a temporary slowdown in the economy in the third quarter of 2016–17. Reports suggest that major sectors of the economy face a slowdown, be it agriculture, industry, services or the organised and unorganised sectors. The Reserve Bank of India (RBI) has taken a cautious stance in its recent monetary policy statement stating that due to the influences already visible in the second quarter, the economy would slow down by 0.5%, but due to the uncertainty created by the demonetisation, the full impact cannot be gauged at present.

Heart-rending accounts of people dying, of a father not being able to save his child because he could not get medical attention due to his inability to get new notes, or of people collapsing in the long queues at the banks have appeared. An economy which the government claimed as the fastest growing economy in the world is suddenly facing a crisis due to demonetisation.

This article looks at the nature of money supply and its link with transactions in the economy. It then discusses the modifications needed to include the presence of the unorganised sector and the black economy. This aids incorporating the differentiation in the Indian economy which will help us understand the impact of demonetisation. Finally, within this framework, the impact of demonetisation on money supply and the output of the economy is analysed.

Money Supply

Money has taken different forms over time. From metal coins to paper currency to credit cards and now to electronic money, its form has changed. Money is not only cash in hand but also bank and post office deposits which can be used to make payments. Earlier, money had an intrinsic value in terms of the metal (copper, silver, gold, etc) contained in it. Now it is paper money which has little intrinsic value compared to the value it represents. This is "fiat" money. It is declared to have a certain value by law, so, it is called legal tender. The note in hand says, "I promise to pay the bearer the sum of one hundred rupees" for a ₹100 note. It is a promise that is never redeemed. If one goes to the central bank with a ₹100 note and asks that one be paid, the bank will give another similar note or two ₹50 notes.

Money is not something that is consumed. In a modern economy, money facilitates transactions—exchange of goods and services—which is crucial for production and generation of incomes. It removes the need for a double coincidence that is required in a barter economy where exchange becomes circuitous and leads to high transaction costs. Money is also needed for precautionary motives. People keep money for an emergency. Further, it is held as a store of value. So, it is one of the items in the portfolio of assets accumulated over time.

While the central bank releases the cash circulating in the economy (broadly referred to as <i>M</i><sub><i>0</i></sub>), the banking system as a whole creates more money by lending the deposits it gets to others. This money is spent by those taking the loans and it flows back to the banks which then lend it out again. So, a multiple of the initial deposit is created as money (called <i>M</i><sub><i>3</i></sub>). The money multiplier is, crudely speaking, the ratio of money in the economy to the cash that the central bank (RBI in our case) releases in the economy. This multiplier rises as the public uses less and less of cash and more and more of the deposits with the banks. The reason is that cash held by the public is a leakage from the banking system and not available to be further circulated. Similarly, the central bank requires the banks to keep a certain percentage of their deposits as cash with it (called the cash reserve ratio [CRR]). As this ratio rises, there is a further leakage, and the multiplier falls.

India is characterised by a large unorganised sector which uses more cash and less of bank transactions, and that reduces the value of the multiplier in the economy.

Structure of the Economy

<p>If purely the transaction aspect of money is analysed, then standard theory tells us that money <i>(M) </i>is used many times in a year for purposes of transactions. Say, from the consumer to the shopkeeper to the wholesale dealer to the producer and back to the worker. How many times it goes around in a year is called its velocity of circulation <i>(V)</i>. So the total of transactions are <i>M</i> multiplied by <i>V (M.V)</i>. Suppose the total transactions in a year are <i>T</i> and they have an associated average price <i>(P)</i>, then the total demand for money is <i>PT</i>. Since the supply equals the demand in this case,

<p>M.V = P.T ...(1)

In this aggregate relationship, a lot of variation is hidden since the Indian economy is very heterogeneous. One of the important differentiation is that between the unorganised and the organised sectors—what are broadly also called the informal and the formal sectors. While the former distinction refers essentially to the unionisation of labour or lack thereof, the latter refers to the registration with the official agencies. It also roughly corresponds to the distinction between the cottage and micro enterprises, on the one hand and the small, medium and large scale enterprises, on the other.

The unorganised sector operates substantially outside the formal banking channels and uses cash for its transactions while the organised sector uses both cash and banks. So, for the unorganised sector it is <i>M</i><sub><i>0</i></sub> that will be relevant whereas for the organised sector it would be <i>M</i><sub><i>3</i></sub>.

<p>So, we can rewrite equation (1) as:

<p>M<sub>u</sub>.V<sub>u</sub> + M<sub>o</sub>.V<sub>o</sub> = P<sub>u</sub>.T<sub>u</sub> + P<sub>o</sub>.T<sub>o</sub>. …(2)

where <i>u</i> stands for the unorganised sectors and <i>o</i> for the organised sectors.

Another important aspect of the Indian economy is the existence of a large black economy. According to estimates, it is 62% of GDP in 2012–13 (Kumar 2016a). Money in the economy has to circulate in both the black and the white economies.

<p>So, we should write equation 1 as:

<p>M<sub>w</sub>.V<sub>w</sub> + M<sub>b</sub>.V<sub>b</sub> = P<sub>w</sub>.T<sub>w</sub> + P<sub>b</sub>.T<sub>b</sub> , ...(3)

where <i>w</i> refers to the white economy and <i>b</i> to the black economy.

<i>V</i><sub><i>b</i></sub> and <i>V</i><sub><i>w</i></sub> are likely to be different given the different institutional practices in the two components of the economy. For instance, because the black income earners try to spend the cash they generate more quickly, the velocity of circulation is likely to be higher for the black economy than for the white economy. Also, consumption expenditures may be incurred first out of the black incomes and then the white incomes. This would mean that the savings propensity out of white incomes would be higher than that of the black incomes. However, for other reasons (Kumar 2005) the savings propensity of the economy rises as the ratio of black economy to gross domestic product (GDP) rises. Further, many activities in the black economy generate transfer incomes and not factor incomes so that the velocity with respect to incomes would be higher.

<p>Given these institutional differences,

<p>V<sub>b</sub> &gt; V<sub>w</sub> … (4)

The implication is that a smaller amount of money per unit of income is needed to transact the black economy. This has further implications for money supply and velocity of circulation which are discussed below.

(i) It may appear that the black economy would be mostly outside the formal systems, so that <i>M</i><sub><i>b</i></sub> may be expected to be more akin to <i>M</i><sub><i>0</i></sub> and the <i>M</i><sub><i>w</i></sub> likely to be more akin to <i>M</i><sub><i>3</i></sub> since it would operate more through the formal system.

(ii) However, this is not a correct assumption. The black and the white economies are intertwined so that funds move from one component to the other smoothly. A bulk of the black incomes are generated in the formal sectors via under- and over-invoicing of costs and revenues (Kumar 2006). Further, as argued earlier, a large part of the white economy is in the informal sector, which uses cash. On the whole, a lot of cash with businesses is used as working capital, both for the black and the white economy. Thus, it is difficult to distinguish between the two sectors of the economy in terms of their use of money.

(iii) The ratio of cash to GDP is lower due to the existence of the black economy. A given amount of currency released by the central bank has to circulate a larger amount of transactions and incomes. The white (₹150 lakh crore) plus the black economy (₹93 lakh crore) currently amounting to ₹240 lakh crore was being circulated by about ₹17 lakh crore of currency and the money supply created by the banking system. Of the total economy, 38% is black and a proportionate amount of the money supply would be needed to circulate the black economy of ₹93 lakh crore. The implication is that the ratio of cash to GDP is lower (0.07) rather than what it appears to be (0.11), if the black economy is ignored.

(iv) The black economy impacts the multiplier since it also requires cash as working capital and for precautionary motive and as store of value, as argued earlier, so that the leakage from the money flow in the economy is greater than that implied by the white economy alone. This would lower the value of the money multiplier compared to what the white economy alone would imply.

(v) A given amount of cash released in the system circulates less if only the white economy is counted. Thus, official data shows a lower velocity of circulation than the actual, where the black transactions should also be counted.

Impact on Money Supply

Demonetisation has reduced the cash in the economy because the old notes are no more legal tender for most purposes (some exceptions were announced for specific purposes). The public is allowed to deposit the old notes in the banks up to a certain date. These become the public's deposits with the banks. So, while currency in circulation <i>(M</i><sub><i>0</i></sub><i>)</i> sharply contracted, the deposits with the banks increased slowly so that the money supply <i>(M</i><sub><i>3</i></sub><i>)</i> in the economy also contracted. Since the money deposited by the public with the banks was to be returned to the central bank, it was not available to the banks to lend out immediately. Further, the banks were too busy with the return of the currency and the issuing of new currency so that they have had no time to lend the money they had collected. Finally, the money that has come in is only temporary since the public is likely to draw it back for the purposes for which it held the currency.

Expenditures by the public have fallen sharply since they have lost their capacity to spend. Discretionary expenditures have been postponed and hoarding of currency is going on, leading to non-circulation of money (which is newly released by the banks and the small denomination currency already in circulation). Thus, the velocity of circulation has come down.

The implication of a decline in both <i>M</i> and <i>V</i>, from equation 1, is that <i>P.T</i> has to also fall. Since <i>P</i> has not yet fallen (wholesale and retail prices are still rising, though less than earlier), it is <i>T </i>that has contracted. <i>T</i> translates into incomes so there is a corresponding fall in production and incomes. The sectoral implications are also important and need to be spelled out.

As stated above, demonetisation has led to a sharp decline in <i>M</i><sub><i>0</i></sub>, so the unorganised sector is adversely affected directly and they have suffered an immediate contraction in transactions and consequently in output. This affects demand in the entire economy since this sector still produces 45% of the output and the impact would spill over to the organised sectors. So, the organised sector which is less dependent on cash is also immediately affected, though less so. Further, in the economy as a whole discretionary spending has come down, leading to a further decline in demand for both sectors. Thus, the rate of growth of the economy as a whole would come down sharply starting with the unorganised sectors of the economy. This has been visible in the economy since 8 November 2016.

Working capital for the unorganised sector has dried up, impacting the small and cottage industry leading to a decline in output in the affected sectors. In fact, if the funds are diverted to production in the black economy because of the higher premiums and returns available there, the shortage of funds for the white economy may increase further and lead to a sharper decline in output in the white economy than in the black economy.

Shopkeepers and their customers may have to give loans to each other to enable transactions to take place. This would mean a need for increased amount of working capital precisely when it is short. Farmers may have to be content with paper from the wholesale dealers promising to pay them later. This is fraught with uncertainty and risk. So supplies to the markets may slow down and lead to a rise in the prices of essentials. The bulk of the labour in India is in the unorganised sectors and is paid largely in cash and not via bank transfers. An auto driver or a head-load worker may find their work declining because people do not have small change to pay them.

It is incorrect to identify the unorganised sector with the black economy as some (especially the Western analysts) do. In India most incomes in the unorganised sectors are below the taxable limit, so whether reported or not, they are not necessarily black incomes (Kumar 1999). Thus, a contraction of the unorganised sector does not amount to a contraction of the black economy. However, from equation 3, even the black economy's growth would be adversely affected due to a fall in <i>M</i> and decline in <i>V</i>.

Shortage of currency would lead to emergence of near money forms. People would use more of gold and foreign exchange for high value transactions. This would be made easier by the availability of the newly minted gold coins of high value under the gold monetisation schemes. Further, because of a decline in trust in the system after the sudden demonetisation and the trouble the public has had to go through, people will shift to other money forms. Thus, over time the rupee could depreciate and more inflow of gold may take place.

Higher use of credit cards and debit cards may follow. Use of cheques in India is limited due to the fear of associated fraud. People bounce their cheques in spite of Section 138 of the Negotiable Instruments Act which made it a crime because cases under this section take years to be resolved and those aggrieved to get justice. But this will only be true for the well-off sections of the population and those in urban areas, but not the poorer sections who have limited access to these instruments.

The uncertainty introduced by the move will also mean that people will hoard more of the small currency and the new money than they need, thus leading to shortages of currency for longer than necessary, thereby ensuring that the adverse impact will last longer than expected.

Impact on Macro Variables

It has already been pointed out that demonetisation by creating a shortage of currency has impacted the money supply through the money multiplier. It has also affected the velocity of circulation so that the transactions in the economy have been forced to contract leading to an impact on production and income generation.

Is this reversible with the restoration of liquidity over time? Indeed, in the short run, this is feasible but not if it persists for more than a month or so. Profitability of enterprises has been dented due to a decline in production and the build-up of inventories. As capacity utilisation was already a problem, it will fall further and this would lead to a cutback in investment and employment. This would result in long-term consequences and the situation could become irreversible.

If after a while due to a decline in demand, prices also fall, asset prices could also drop and this would impact demand from the well-off sections of the population. This would be on top of the fall in discretionary demand. The effect would then become more long-lasting.

Demonetisation may destroy a tiny part of the black wealth but it would not stop black income generation (Kumar 2016b). In the case of real estate, white and black prices may both fall. However, it is possible that the white price falls more leaving the black price more or less unchanged. Thus, black wealth may remain unaffected while white wealth falls.

One of the arguments given in favour of demonetisation is that tax collection would go up, allowing the government to spend more on pro-poor schemes. This expectation may not be fulfilled since the money being deposited in accounts is being put mostly in small parcels which will be below the taxable limit. The income tax department is also not equipped to deal with such a large number of cases. So, not much of the black economy may be unearthed by the present move. More importantly, any gain due to bringing a small part of the black economy in the tax net would be more than annulled by the big decline in the white economy (being witnessed) and the loss of tax collection there.

It is also argued that the banks are now flush with funds and they can lower the lending rates thus benefiting production. This is unlikely to happen in a hurry since banks are too busy dealing with the currency shortage to have time to lend, etc. Also given the uncertainty, investment and demand for funds would decline. Finally, in a period of demand shortage, lower interest rates would not lead to increased demand or production. Yes, enterprises would get some benefit of lower costs.

All in all, a move that was expected to be a historic high for the government is leading to a crisis where there was none before the announcement of demonetisation. Even now, an immediate release of liquidity already with the banks can lead to a reversal before irreversibility sets in.


Kumar, A (1999): <i>The Black Economy in India</i>, New Delhi: Penguin.

— (2005): "India's Black Economy: The Macroeconomic Implications," <i>South Asia: Journal of South Asian Studies,</i> Vol 28, No 2, pp 249–63.

— (2006): "Black Economy, Under Estimation of Employment and the Union Budget," <i>Economic &amp; Political Weekly</i>, Vol 41, No 30, pp 3315–20.

— (2016a): "Estimation of the Size of the Black Economy in India, 1996–2012," <i>Economic &amp; Political Weekly</i>, Vol 51, No 48, pp 36–42.

— (2016b): "High Price, Uncertain Gain," <i>Indian Express</i>, 18 November.


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