The impact of demonetisation (‘demon’), which should have been called remonetisation, has been measured anecdotally in terms of queues at ATMs, or the reported number of shopkeepers ruined or casual workers who have ‘lost’ their jobs, etc. There is also justified criticism of the many changes RBI has announced in the amounts people can withdraw, etc.
None of this is economics. Economics has well-known ways of judging the impact of changes in the quantity of money on income and prices. The two well-known ways are the Quantity Theory of Money (QT) which is written as MV=PT, and the Cambridge Equation (CE) of the demand for money—M = kPY. (P is price level, Y real income, M the quantity of money, and V and k measures of velocity).
QT, in a way, is an identity. If we take each transaction as f in terms of its money value, then the sum of the money value of all transactions £f bears a relation to the amount of money available. More transactions can be accommodated if the money changes hands faster, i.e., if the velocity V is high. £f is broken into P, the price level, and T, the number of transactions. Irving Fisher, the renowned Yale economist, actually measured the variables in QT. No one else has done it since.
There is no simple way of translating PT into PY; even with the definition of P, the price level would be different in the two cases. We are told that the size of k, the proportion of cash to nominal GDP, is around 0.12. This is assuming that while we know C accurately, the estimate of nominal income PY is accurate. This is unlikely if the ‘black economy’ is a significant part of the total. So, the effect of a reduction in cash on income has to be estimated in an indirect fashion.
The important thing for analysing ‘demon’ is that there has been a drastic reduction in M. A reduction in M should lead to a parallel reduction in transactions given that V does not change much in the short run. The stories we read about tell us that this is indeed what may have happened. People can’t buy and can’t sell due to lack of cash.
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But ‘demon’ has been trickier than a mere reduction in M. If we break down M into cash (C) and bank deposits (D), then what ‘demon’ has done is to compel the shift of C in form of old currency into D. Once M has become D, it can theoretically be used/circulated by writing a cheque. As old currency as cash has been devalorised, new currency is supposed to take its place. It is the slow growth of new cash—call it C’—which has caused a lot of problems.
So, the real reduction in M amounts to the leakage in C to D, the amount of cash-hoards not returned to banks. This seems to be around 10% . To this, you have to add the fact that the non-banking public has seen a reduction in their old cash holding but not sufficient injection of new money. The initial shock is reduction of C to zero in the first fortnight of ‘demon’ since November 8, but very slow emission of new currency. Any withdrawal from bank deposits in the form of new currency was slow due to restrictions due to the availability of new currency.
The initial shock is then a reduction in cash due to transfer of C into D plus slow conversion of D into C’. Since cheque and card transactions continue, the impact is on those transactions which are cash-based and cannot be delayed. Thus, daily purchases of perishables and services have shrunk. Durable (high-value) purchases should have suffered less, if at all, as they are mostly done through bank-transfers. To the extent that these transactions were done through cash, presumed to be black money, they have either ceased (the desired effect of ‘demon’) or been carried out at higher prices because of the fear of devalorisation of old money. This temporary rise in price due to laundering will be reversed soon and durables such as real estate and jewellery will fall in price (another desired effect of ‘demon’). Thus, nominal consumer expenditure will fall, but the real reduction will be less.
The negative income effect should therefore be small and reversed as and when new currency flows back into circulation. There is some evidence that the emission of new currency is increasing. If so, we should expect some reduction in the growth rate of income in the second half of the third quarter of FY17, with a bounce back in the fourth quarter.
Over the two quarters, I expect the income effect of ‘demon’/remonetisation to be negligible—around 0.5%.
The author is a prominent economist and Labour peer