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Economic Impact of Demonetizing the Indian rupee

Indian Economy has far been a victim of black money and corruption. The Indian system looked incorrigible resulting in crores of unreported money flowing in and out from the country. The Modi Government, in order to curb the flow of black money came up with the Income Declaration Scheme (IDS), which gives holders of undeclared wealth a chance to come clean by paying tax, surcharge and penalty of 45 per cent and escape punishment. This scheme however, did not turn out to be successful. The PM, in an unprecedented move banned the five hundred and thousand rupee notes on 8th November in an attempt to resolve the issues of corruption, black money and counterfeit notes. The RBI will issue new notes of two-thousand and five-hundred rupee. Other denominations however, will not be affected by this decision. The so called surgical strike on black money is expected to cleanse the Indian economy and bring in various unorganized sectors which account for a large part of the Indian Economy into the formal and registered part of the Indian banking system.

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The effect on stock market on the day of announcement the demonetization.

Short term consequences of this decision on various economic variables and entities

  • Effect on parallel economy

The removal of these 500 and 1000 notes and replacement of the same with new 500 and 2000 Rupee Notes is expected to

  1. Remove black money from the economy as they will be blocked since the owners will not be in a position to deposit the same in the banks.
  2. Temporarily stall the vast circulation of counterfeit currency and – curb the funding for anti-social elements like smuggling, terrorism, espionage, etc.
  • Effect on Money Supply

Until the new 500 and 2000 Rupees notes get widely circulated in the market, which is a huge task as the only outflow of these notes is through banks or ATMs, money supply is expected to reduce in the short run. However, money supply will pick up gradually (2-3 months) as the new notes get circulated in the market.

  • Effect on Prices level

Price levels are expected to be lowered due to moderation from demand side. This demand driven fall in prices could be understood as follows:

  1. Consumer goods: Marginal fall of prices is expected due to moderation in demand as use of cards and cheques would compensate for some purchases.
  2. Real Estate and Property: Prices will fall drastically in this sector because major part of the transaction is cash based. In the medium term, the prices could regain some levels as developers rebalance their prices (maybe charging more on cheque payments).
  • Effect on various economic entities

With a temporary cash crunch, certain sections of the society (majorly the unorganized sector) could face short term disruptions in facilitation of their day to day transactions. These sections are:

  1. Agriculture sector
  2. SME
  3. Services Sector
  4. Household sector
  5. Political Parties
  6. Professionals like doctor, carpenter and other utility service providers, etc.
  7. Retail outlets will have the most significant impact of the demonetization decision.
  • Effect on Banks

Bank accounts will be flooded with cash. However, these are mostly emergency funds and therefore there would be withdrawals at a later stage.

  • Effect on Online Transactions and alternative modes of payment:

Alternative forms of payment will see a rise in demand. Digital transaction systems, E-wallets, apps, online transactions using E-banking, usage of Plastic money (Debit and Credit Cards), etc. will definitely see substantial increase in demand. This should effectively lead to strengthening of such systems.

Future Analysis with respect to the loanable funds market

With heavy cash inflows in savings and bank accounts, the supply of the loanable funds market will increase drastically. The Supply Demand curve plot with Loanable funds and interest rates as axis will help understanding the effect of demonetization. Due to increase in supply of deposits, the supply curve will shift to the right. It will then intersect the demand curve at a new equilibrium resulting in decrease in the bank interest rates. This is shown in the graph below.

graph-shown-below

  • There could be a double digit inflation rate seen due to a triple effect of Demonetization, the GST Bill and the 7th pay commission.
  • Due to decrease in the bank interest rates, the Investment sector (under GDP Expenditure approach) will see a huge boost in demand as more people will see this as an opportunity to invest in an instrument which pays more interest than the charged bank rates.
  • The consumption sector will also see a boost as a middle class family will spend more money due to easy availability of cash. For example money spend on buying a new car or a house.
  • The Government spending, which is the net of taxes earned and government expenditure will reduce due to increase in taxes earned. This will help improve the budget deficit.
  • Net exports: The Real effective exchange rate will also reduce resulting in a more competitive economy on a global scale.

To cut excess liquidity in the market, the government would then decide to issue bonds at lower tax rates. The money raised from bonds and also through taxes paid by the holders of undisclosed wealth would then be redirected to reduce government debt. This would help in relaxation of various public sector units which are under a debt crunch.

Conclusion

This move is a vital step to curb the circulation of black money and counterfeit notes in the economy. However, India still has a long way to go in providing a digital infrastructure which in turn would provide a framework to keep track of the undisclosed income. There is also a risk of the two-thousand rupee note again starting the vicious circle of black money at a much higher rate this time. Therefore, a digital infrastructure and its coordination with the Income tax department would help achieve the desired goal of the government.

References

http://economictimes.indiatimes.com/news/economy/policy/what-is-demonetisation-and-why-was-it-done/articleshow/55326862.cms

http://www.careratings.com/upload/NewsFiles/SplAnalysis/Effects%20of%20Demonetization%20of%20500%20and%201000%20notes.pdf

http://www.careratings.com/upload/NewsFiles/SplAnalysis/Effects%20of%20Demonetization%20of%20500%20and%201000%20notes.pdf

http://scroll.in/article/821073/note-demonetisation-86-of-indian-currency-and-12-of-gdp-has-been-frozen-overnight

http://www.livemint.com/Money/WZMX0fj5YQKOU4l6P0J44I/Demonetization-of-rupee-has-hit-the-Indian-markets.html

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Categories: Story Of The Week

2 replies »

  1. Deflation will happen first, for the next 6 months to 1 year. Gold prices will drop, stocks & commodities will drop. Everyone will get excited and congratulate the government for making this move.
    Then slowly, as lending activity goes up, the broad money supply will go up and prices of all things would go up, slowly and steadily.
    Now no one can predict the extent of the deflation and inflation. In an ideal world, if 100% of the people who have Rs.500 and Rs.1000 notes have it as white money, then we would see only inflation. If a lot of these are black money and if many people decide to waste the money instead of depositing it, then we will have deflation in the short term.

    Ref : https://yourstory.com/2016/11/ban-rs-500-and-rs-1000-notes-affect-common-man/

  2. Well written!

    On Sun, Nov 13, 2016 at 10:57 AM, The Economics Club at IMI wrote:

    > Economics Club IMI posted: “Indian Economy has far been a victim of black > money and corruption. The Indian system looked incorrigible resulting in > crores of unreported money flowing in and out from the country. The Modi > Government, in order to curb the flow of black money came up wi” >