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The demonetisation of the 500 and 1000 rupee denomination notes has removed 86 per cent of the currency from circulation. It is argued that there are agents in the economy who are hoarding currency as a method for storing savings, especially by people earning unaccounted or illegal incomes. Demonetisation has been introduced for reining in the unaccounted incomes/wealth in the economy. It is being argued that the part of wealth held by people as cash would be extinguished as a result of demonetization and that there is going to be a temporary disruption in the economy. The effects on the economy, however, depend on what we assume about the money that would be extinguished – is the money being used for financing unaccounted transactions or accounted ones or is it being used as a way to save. If the former is the case, then even if unaccounted, the impact on the economy will be large and the resultant impact on employment too would be significant. For instance, if Rs 3 lakh crore is being extinguished as is often quoted in various media reports, and say half of it is used for transactions. Since, presently GDP is about 8 times the currency in circulation, the corresponding GDP loss to the economy would be Rs 12 lakh crore. This will amount to about 8 percent of GDP when compared to GDP for 2015-16. This is without factoring in the effect of the all-round compression in demand with demonetization. In other words, there would be a non-negligible impact on the economy in the short term. In terms of the observable impact,  there would be a severe compression in demand in the next one to two months until the currency to be replaced gets back in circulation.


The other question to ask is whether the currency surrendered to the banks would be fully replaced in circulation. If the currency is not fully replaced with the expectation that people would move to transacting through digital mediums, then the transition costs and the time will be substantially longer and the disruption to business, too, will be large. The transition costs will be for banks and other intermediaries as well as for agents in the economy who have to learn to comprehend transactions which do not have the same degree of transparency or salience as cash based ones.
The impact on the government budgets would have different effects depending on whether the currency is completely or partially replaced. Indirect taxes could increase in the very short term as people might spend balances to avoid holding them. However, with compression in the economy and in consumption, the tax collections should be adversely affected. Income tax collections will depend on the extent to which unaccounted balances get deposited in the account. If these balances are large, then tax collections will increase otherwise, the tax collections will decline. If the balances deposited in the banks are not completely remonetized, then there will be increase in potential credit in the economy which can only be realized if there is demand in the economy. If the credit expands, the government will get access to additional funds as a part of the SLR commitments of the banks. This could potentially lower the cost of borrowing to the government, if all of this happens. In the medium term, the benefits will depend on whether a perception can be created of the possible enhanced risk associated with unaccounted incomes thereby forcing more people to report more accounted incomes.
The above commentary is based on NIPFP WP NO. 182 titled, "Demonetization: Impact on the Economy".
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