Demonetization — The economic impact

The hot topic in India on which everyone has a point of view — Demonetization.

So here is my take on the subject. Not an opinion but an understanding of fall outs of any demonetization by any country.

Demonetization literally means stripping something of its monetary value. E.g. recently in India, the government scrapped the value of Rs 500 and Rs 1000 notes, making these notes nothing more than colourful scraps of paper.

In an economy which works on the principle of cash (as against barter or other forms of exchange), the central bank of the country prints currency denominations. Only the central bank can decide how much currency there should be in circulation within the economy. Printing too much currency in the hope that everyone will get some money can lead to hyper inflation (e.g. Zimbabwe). Printing too little can lead to a stagnant or deflationary economy.

If another country prints the same currency and infuses it into your economy, they can effectively influence the monetary policy and inflation rate depending on the quantum of duplicate currency pushed into the economy.

Demonetization removes the value of money from a printed bill. If the demonetization is very sudden, it fails to give non state actors / other countries sufficient time to react, thereby restoring monetary policy control to your own central bank. This can only be a temporary reprieve depending on how quickly other countries can react.

The second thing which a demonetization drive does is forces everyone to put all the currency in circulation into the banking system, because that currency has no use anywhere else. As a result the Current Account / Savings account cash availability increases, thereby increasing the ability of banks to lend. Depending on how ethical the banking system of a country is, in best case scenarios the funding could flow into capital intensive sectors such as roads, railways, power or telecom.

Thus on paper, a suddenly announced demonetization scheme is good news for any country. The more the cash reliance of the country, the better it is for the nation.

The end result however all comes down to execution, which means plugging all the holes in the system.