Economic Consequences of Demonetisation: Money Supply and Economic Structure

Prof Arun Kumar is the foremost authority on the subject of black money. In an earlier interview he had explained that this exercise will not lead to much gains for the government.

Now in another piece in EPW, he puts all the ideas together and explains how we should think about the issue. This is as good as it gets. He starts with concept of money supply and what demonetisation does to it. Then he takes the money supply argument to see the impact on economic structure.

He sums up:

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.

But do read the whole thing. Talks about lots of inter-related issues which have been missing from most analysis..

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