Reasons given for demonetisation  

• To control counterfeit notes that could contribute to terrorism
• To undermine or eliminate black economy
  

How pre-demonetisation money will stand altered

•  There would be agents in the economy who are holding cash which they cannot explain and hence cannot deposit in the banking system. This part of currency will extinguish since it can’t be replaced.
•   The government may choose to replace only a part of the currency which was in circulation as cash. The rest would be available only as electronic money. This could be a mechanism used to force a transition to cashless medium of exchange.

Broadly, there are four types of transactions in the economy

• Accounted transactions
• Unaccounted transactions (These relate to whether transactions and the corresponding incomes are reported for tax purposes or not)
• Transactions in informal sector (would mostly be exempt from tax slabs)
• Illegal transactions (is used for bribes in elections, spending over sanctioned limits, dealings in crime and corruption)

Effects of demonetisation

• It depends on the extent to which the currency is extinguished and what this currency was being used for.
• It is assumed that the currency that will extinguish is the one that was stored to be used for alternative investment options – like buying property, lending in the unaccounted or informal sector, etc. which yield better results than cash. Impact of extinguishing of this currency would be limited.
• If the currency was stored to be used as medium of exchange, then the impact on economy could be substantial. For instance, if this money was used to pay for work in the informal sector, then demonetisation would result in these works shutting down. As a result, income and employment in these sectors would drop.
• Now, the question is – will these informal works come under the fold of formal sector or be extinguished in the changed economic scene?
• Another change from demonetisation will be seen if only a part of the currency deposited in banks is returned for circulation as cash. This will dramatically change the economic environment, forcing people to move to using cash subsidies as mediums of exchange. These would be credit and debit cards, pre-paid cards, mobile and internet banking. The RBI and the finance ministry have been repeatedly pushing for this

Very short-term impact

• 86% of currency in circulation has been demonetised. There are not enough mediums of exchange available. This would mean severe contraction of income and consumption in the economy.
• This effect would be more severe on individuals who earn incomes in cash and spend them in cash. It will also affect people who earn income in non-cash means but need cash for consumption. A lot of sectors in the economy still work predominantly with cash.
• Sectors to be adversely affected are all those where demand is usually backed by cash and not within the organised retailing, like transport services, kirana, fruits and vegetables. These sectors depend heavily on purchasing power of people. This, in turn, can have two effects: If supply exceeds demand, it will lead to fall in prices. But if supply is curtailed, prices might rise.
• People might opt for credit till the liquidity status is settled. In such a scenario, prices might rise.
• Demand of non-essential goods might fall.
• The demand in the real estate sector from people who have unaccounted cash to be used in this sector will fall. Either prices in this area will fall or transactions will stop. This can be a positive development in this sector but overall investment in construction sector will fall. It will have a direct adverse impact on income and employment.
• Spin-offs from this change – increase in tax collection in the short-term, and various IOUs could emerge as currency substitutes.

Short-term effect with complete replacement

• This will depend on the speed with which and the extent to which cash is replaced by the authorities.
• If the entire cash is replaced within a short duration of time, the effects beyond the very short term of 1-2 months might be little.
• The sectors which have large employment effect on economy can be seriously affected. These are – agriculture, automobiles and construction.

Agriculture

• This is the sowing season for the Rabi crop in some parts of the country and harvesting season for the Kharif crop. Most of the purchases and sales are carried out through cash.
• With the elimination of cash from the economy, sale of Kharif crop would be difficult unless the crop is sold on the promise of payment in future.
• Farmers have low bargaining power – they may not get the required prices for their crops.
• For sowing, farmers may not get inputs as most of them are purchased from the market unless they seek access to credit from the supplier. Demonetisation would lead to significant strengthening of the informal sector credit market in the rural economy.
• Thus, in spite of a good monsoon in large parts of the country, the farmer might not get the benefits.

Short-term effect with incomplete replacement

• If only a fraction of the total cash surrendered by people is replaced by authorities, then people would be forced to use digital versions of money as medium of exchange.
• While this change is gradually happening, if it is forced by making cash inaccessible, the compression in demand as well as in income generation in the economy would continue for a longer period until people get familiar with the functioning and use of these media.

Medium-term effects

• If the entire currency is replaced, there would not be any major effects on the economy. If not, the effect would be as follows:
• A compression of the economy to the extent the extinguished currency was working as a medium of exchange.
• The currency in banks that is not withdrawn would generate an expansion in deposits in the economy.
• There is a consistent reference to the resultant increase in credit creation in the economy. Like finance minister Arun Jaitley says, “Bank deposits will increase and they will have more capacity to support the economy.”
• (As per calculations in the paper) The additional credit creation can be 25 times the amount of money deposited in the banks as a result of demonetisation. But, this amount will be generated only if there exists an equivalent demand for credit in the economy.

Transition issues

• Infrastructure: Need for an upgrade of the banking as well as of the telecom infrastructure. This is needed for digital transactions. In many parts of the economy, there is limited and intermittent supply of electricity as well as mobile connectivity. In these areas, it would be difficult to expect people to shift to electronic medium of exchange.
• Consumer behaviour: To get used to moving from cash to non-cash means.
• Language barriers: There are limited languages in which transactions can happen over mobiles, etc. There is a need to expand this.
• Issues for banking sector: Agents who were operating through cash would now have to move to non-cash instruments and hence, the balances in their accounts would not be savings but transaction values which will be retained in the account for shorter durations of time. The banks therefore would need to re-model their decisions on how much of the deposits can be lent out and for what duration. Until people adjust to the use of non-cash instruments, there would be an increased demand for the cash that is available and that might generate a situation where the agents have to pay a premium to access cash. There would be two implications of this development: First, if the premium on cash is high, it would encourage both the shift to non-cash instruments on one hand and to informal substitutes of cash on the other. And second, this might undermine the confidence that people have in the currency and hence, encourage move to other currencies.

Mode of payment and spending behaviour

• While cash limits one’s ability to spend to the amount of cash in hand, a debit card expands it to the balance available in the account and a credit card further relaxes it to include future earnings as well.
• In comparison of debit cards with cash, studies suggest that with the use of debit cards, the level of consumption tends to be higher.
• In comparison of credit cards with cash, use of credit cards is even higher than debit cards. 
• Spending with cards encourages spending on non-essentials as well.
• This changed spending behaviour can lead to increased consumer debt, which in turn could push the financial system towards a crisis if not suitably managed.
• Further, if available debt in the economy is channeled towards consumer debt, while at the same time lowering saving in the economy, it could adversely affect the investment within the domestic economy.

Impact on macro variables

• Two changes that demonetisation    can bring in money supply: First, if the demand for credit in the economy is large enough, at least a part of the credit will be for productive purposes. This would mean expansion in investment in the economy and subsequently an increase in GDP and employment. And second, if there is increase in investment in the economy, the demand for capital goods rises.
• But in the short run, there is a possibility of increase in inflation.
• With increase in GDP, it is expected that imports will rise, but the same cannot be said about exports. The balance of trade could worsen. This could result in pressures on the rupee towards depreciation.
• It should not be assumed that the expansion to credit will definitely materialise. In the last two years, the demand for credit in the economy has been sluggish. There might be many factors that contributed to this outcome, what is of consequence is that the demonetisation has been introduced in this environment where demand for credit is rather low. This would further depress investments.
• A consequence of this could be fall in interest rates. This can help firms already under debt.
• Fall in demand would mean low imports, but exports might not be affected.
• Low interest rates may not bring additional demand. This means banks will have deposits and they might give them away to risky businesses. This may bring more volatility in the system.
• There could be social unrest if the compression in incomes and consumption are severe and persistent.

Alternatives to currency

• At present, there are coupons like the Sodexo which are used for paying for certain purchases. These are accepted by a range of establishments in place of formal currency. It is, therefore, possible to see an expanded use of these coupons.
• For high value transactions one can think of bitcoins and other such crypto currencies on one side and foreign exchange on the other as a mechanism for settling transactions.

Effect on government finances
Impact through taxes 

• People have attempted to convert cash balances into commodities like gold or luxuries. On these transactions the governments would have a spurt of taxes. This would however not last beyond the transition phase.
• Subsequently, indirect taxes will fall as demand will fall.
• On property taxes, some local bodies have given people a window of opportunity to pay old as well as current taxes in the scrapped notes. This would result in an increase in revenue collections in property tax.
• On income tax, the government cannot expect to get major collections in terms of the tax and penalty on unaccounted incomes revealed.

Conclusion

• While it has been argued that the cash that would be extinguished would be “black money” and hence, should be rightfully extinguished to set right the perverse incentive structure in the economy, this argument is based on impressions rather than on facts. 
• While the facts are not available to anybody, it would be foolhardy to argue that this is the only possibility.
• While the cash was mediating in legitimate economic activity, if this currency is extinguished there would be a contraction of economic activity and that is a cost that needs to be factored in while assessing the impact of the demonetisation on the economy and its agents.
• It is likely that there would be a spurt in the banking deposits as a large part of their deposits were earlier used for transactional purposes and were not savings or hidden black money.
   

The full text of the working paper can be accessed at: click here