Monday, November 14, 2016

Demonetization: Fact and Fiction

Demonetization: Fact and Fiction

Vivek Dehejia

Ottawa, Canada, November 14, 2016

The past week has witnessed a series of surgical strikes on our common sense, with commentary on the government’s demonetization of high denomination currency notes ranging from claims that it is a political masterstroke for Prime Minister Narendra Modi to claims that it is political suicide, from claims that it will be a bonanza for the economy to claims that it will be a disaster. It’s high time to separate fact from fiction, and conjecture (well founded or ill) from propaganda.

First, given that the old 500 and 1,000 rupee notes are being replaced with new 500 and 2,000 rupee notes, what is involved is, in effect, a one time wealth tax on black money. To be more precise, this will be a one time tax on unaccounted cash held in high denomination notes, and therefore represent a partial attack on black money. After all, black money that has been converted from cash into gold, property, or other assets will be unaffected, or at any rate, unaffected directly. (A crash in property prices, induced by demonetization, will indirectly affect the wealth of those who have parked money, whether illicit or otherwise, in the property market.)

That having been said, it would be hard to deny that those with large stashes of unaccounted cash are going to take a hit in the short run, and it will take a period of months if not years for an equivalent stock of black money in the newly printed currency notes to be built up. Black money will take a hit, at least for a while, and that cannot be a bad development.

Second, the costs of demonetization are the short run adjustment costs caused by a liquidity crunch during the transition period in which old notes are swapped for new notes. These are, literally, the shoe leather costs first year economics textbooks write about -- the cost of waiting in a queue to exchange or deposit legitimate stocks of old currency notes. There should be limited or no medium or long run effect on the level of aggregate demand in the economy, a bizarre claim being put out there even by some well known economists who ought to know better.

Thus, celebrated economist Kaushik Basu is quoted in the Financial Times as saying that the demonetization plan is a “very risky correction of money supply” and is likely to cause a drop in aggregate demand and thereby lead to slower growth. This is very puzzling indeed, considering that India now operates under a monetary policy regime known as inflation targeting, a fact which Basu most certainly knows. Thus, if a portion of the stock of high powered money is destroyed by some of the high denomination notes being burned -- literally or metaphorically -- the incipient drop in M1 can be fully offset by open market operations of the Reserve Bank of India. In more technical terms, the RBI, can, to a first approximation, fully “sterilize” the monetary effects of that demonetized currency which is “burned” and not deposited or exchanged for new notes.

More fundamentally, in a world of inflation targeting, unlike the world of the first year textbooks that Basu seems to have in mind, the money supply is endogenous, as the policy instrument is the central bank’s policy rate -- in India the repo rate, not adjustments to the money stock or its growth rate. Thus, in terms of our textbook analytics, the LM curve is horizontal at the central bank’s chosen interest rate, rather than vertical at a policy-determined money stock. The intersection of this horizontal LM curve with the downward-sloping IS curve determines the level of aggregate demand, at a given nominal price level. There is no role here for demonetization to play.

Third, armchair analysts of the short run impacts of demonetization have in some cases succumbed to a very basic confusion, that between a one time change in the price level and the rate of price inflation. Suppose that, because of changed consumer and producer behaviour, there is a one time shock to the price level. This level effect has no effects on the medium and long term rate of inflation, which is a function of the underlying growth in the stock of money, which, in turn, is a function of the central bank’s policy interest rate as determined by its inflation targeting policy framework. This confusion between levels and growth rates equally infects discussion of the Goods and Services Tax, in which it is wrongly argued that inflation will be the result when what is meant is a one time change in the price level.

Fourth, the beneficial effects of demonetization in the longer run are likely to be an increase in financial inclusion, as more of the unbanked are goaded to enter the financial system, and this can only be a good thing. Relatedly, to the extent that those inconvenienced during the liquidity crunch of the transition switch over permanently to debit and credit cards and electronic payments, the economy’s reliance on cash will diminish, although it will by no means disappear (nor should it, for that matter).

Fifth, and last, a long run solution to the problem of black money must tackle it at its source, and that means dealing with hot potato issues such as election finance.

Bottom line: Demonetization is likely to have some good effects, and its bad effects are overhyped by critics who either do not understand monetary economics or perhaps have a vested interest in seeing the laudable efforts of the government to crack down on black money fail. Let us give this a chance.

Vivek Dehejia is economics professor at Carleton University in Canada; resident senior fellow at IDFC Institute in Mumbai; and columnist, Mint, India. He may be reached at

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