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Explained: What Demonetisation Does, And What It Doesn’t 
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What does demonetisation do to a currency, its value and the money supply? Read here.

The Narendra Modi government’s shock move on demonetisation of Rs 500 and Rs 1000 notes has put everyone in a tizzy. Two reasons were advanced for this move – to hit at black money and to check counterfeits. The opposition parties were quick to cry foul and question the first reason. The inconvenienced public has been confused both about the purpose and the processes that have to be followed now.

In this scenario, here’s a ready reckoner on demonetisation.

Demonetisation principles

A currency is a promissory note issued by the government. It promises to exchange goods or services against the note when anybody (usually a resident of the country) produces it. Demonetisation is then a breakdown of that promise, to the extent of the notes which are put out of circulation.

It is thus a very risky step and can be taken only in very exceptional circumstances. It is akin to a sledgehammer attack on the currency system and thus few countries have deployed it. Till November 8, only six nations have used it, including India in 1978. No European or American nation (North or South) has deployed it. Of those who have, only India has gone for partial demonetisation.

What doesn’t it do?

Demonetisation does not cut corruption as has been touted. What it does is to make the stock of unaccounted money illegitimate. That stock could have been built up by anybody or any institution through money laundering, tax evasion or any other means. All the currency notes they hold which has been demonetised become useless piece of paper, since their value as promissory note is stripped away. So demonetisation does not promise there will be no future corruption or other illegality.

But that is not the whole story. By inflicting a cost on those who have committed illegality so far, demonetisation cripples their ability to engage in future corruption or undertake generation of black money. (It is fairly probable that the greatest incentive for doing crime with currency is with those who were engaged in it at present). The costs for these people or organisations become much higher.

So, demonetisation has an indirect but powerful impact on future corrupt practices with respect to currency.

What are the things it does?

Usage of currency is a legacy behaviour from the past centuries when humans evolved from barter systems to the use of money. A currency does four major functions:

  • It acts as a store of value.
  • It allows for exchange.
  • It allows for deferred payment.
  • It is a unit of measurement of value.

A demonetisation exercise, as in this case of the Rs 500 and Rs 1000 notes, blocks the first three functions. It does not stop anyone from indicating the value of her goods or services in Rs 500 or Rs 1000 or in their multiples—unit of account. For other units of currency, say Rs 100 or Rs 10, all the functions are in operation.

When demonetisation takes away the three functions described above, a person with black money is crippled. The only way for him to get back in the currency loop is to exchange the demonetised currency with valid notes. Since the only place in an economy where notes are exchanged are banks and they will ask for trail of the money, life indeed becomes difficult for the tax evader, criminals et al.

What are the options for them?

They can try to buy items of high value to beat the deadline. This is what explains the rush for gold. Real estate deals or buying of petrol\diesel is another option.

If banks diligently monitor exchange of rupee notes, if others like jewellers are blocked effectively from dealing in contraband notes (old Rs 500 and Rs 1000 notes) then there is scarce opportunity for anyone to rid himself of the stock of such currency.

What is the impact of demonetisation on the economy?

Prevalence of black money spawns in an economy in those sectors where the checks and balances are low.

In India, these are sectors like commodity trading, especially of perishable commodities like potato, brinjal, onion and tomatoes for which there is large demand but there are few suppliers.

Similarly, there is high usage of cash in sectors like illegal trade in shares or of commodity scrips (dabba trading). In both of these markets, since liquidity has dried up, it becomes impossible for the traders to either speculate about a spike in inflation to release stocks or even to do circular trading to keep the loop from breaking. For instance, if a merchant hoards onions, he needs to have cash to pay for those. When he doesn’t, his staying power collapses. Similarly, a circular trade in steel or guar gum needs buyers and sellers to keep on the cycle. Once the currency stock of these buyers and sellers is invalid, prices collapse.

Thus volumes in these markets will be the first to fall and indeed they have. For retail consumers this should mean lower prices of several vegetable items this winter, Remember, winter is also traditionally the time when prices of vegetables soar, as the consumer price index (CPI) shows. If this does not happen this winter, it will be an obvious victory ensured through demonetisation.

A lot has been written on real estate sector. But a salient sector where demonetisation will help is in education and health services provided by the private sector. CPI data shows the price of these has risen phenomenally and has eaten up large percentage of income of the lower income groups. To the extent that these transactions were paid for in cash or bearer cheques, it should be great news for everyone.