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With not so encouraging response from its Income Declaration Scheme, 2016, which could unearth just about 0.5% of GDP, the government came out with a surprise policy of discontinuing Rs 500 and Rs 1000 notes from circulation. As the government is determined to curb terrorism financing, counterfeiting as well as the unaccounted incomes, the demonetization measure is clearly a bold one and expected to be effective.  However, as many analysts pointed out, since the share of the value of these currencies is about 86.3% by the end of 2015-16, the success of this policy depends heavily on the speed and smoothness at which the existing currency in circulation is replaced with new currency.   

At a macro level, it would be interesting to know what could be the impact of demonetization policy on the growth, inflation, government revenues, and so on.  In this small note, we try to empirically look at these issues.  However, ex ante, as at this stage, it is difficult to ascertain the degree of replacement, the figures derived here are at best based on partial analysis and indicative, that is subjective to key assumptions.  
Here, following the quantity theory of money framework that explains the long run relationship between money supply, output and prices, simulations are carried out to understand the impact on output and inflation. At present (2015-16), ‘currency with public’ is estimated to be about 13.2% of broad money while at a whopping 75% of reserve money stock, the money multiplier is the largest at about 5.7.  Most risky for this analysis is the assumption about the extent of unaccounted money in the economy.  While the media provided various unauthenticated estimates about the extent of unaccounted incomes in the country, following currency demand approach (by Friedrich Schneider), India’s unaccounted incomes is estimated to be about 23% to 26% of GDP and this could be in the form currency (domestic and foreign), gold & precious metals, immovable assets, etc.  
Following demonetization, what is generally expected is that a major part of currency with the public will be exchanged with new notes and some part of it end up as deposits as well.  This, through money multiplier, could enhance the economic activity substantially.  However, due to unaccounted incomes, the replacement might not be complete and the extent of currency that could not be part of the replacement depends on the extent of black money and might be substantial.  This would have differential impact on GDP growth and inflation in different times.  As per theory, the impact of change in money supply is expected to be significant on output in the short run.  However, in the long run its impact could be highest on the prices but less on the output.  This can be explained through the graph below.  


As demonetization would reduce the money supply due to incomplete replacement in the system, this is expected to reduce the GDP growth not only in the shock year but also in the t+1 period.  However, as some of the currency, which was not part of the financial system earlier, comes back to the banking system and there are policies to increase the cashless transaction in the economy, one should expect the improvement in the money multiplier.  This should have a positive impact on growth and expected to result in higher growth than in the base case.  There are other channels through which positive impact on growth can occur.  They are fiscal channel (through increase in the government revenues) and the banking channel (through downward pressure on the interest rates).  Similar channels and its differential effects can also be seen on inflation.  
Illustratively, assuming that out of the ‘currency with the public’, 25% (close to Schnider’s estimates) is unaccounted money.  Further from this if half of it comes back to the banking system, with half of the money out of circulation, this could reduce the GDP by 1.1% in the current year.  However, due to increase in money multiplier, the drop in GDP is expected to be about 0.6%.  What is interesting is that the positive impact of such improvement in multiplier is much more in 2017-18, where the GDP is expected to be higher than that of in base case, by 0.7%.  In the same scenario, while the inflation also decline, the decline in inflation in 2017-18 is higher compared to decline in 2016-17.  
As discussed earlier, what determines the impact of demonetization is the ease at which the replacement of currency takes place so that there is no significant disruption to normal transactions. Going by the reports that suggest compatibility problems of existing ATMs with the new notes as well as doing away with Rs 1000 notes during the crucial transition period (although as an afterthought, government announced that it could bring back new Rs 1000 notes soon) imply that replacement process could be prolonged and painful.
The author is Professor, NIPFP. Click here for detailed profile.
The views expressed in the post are those of the author. No responsibility for them should be attributed to NIPFP.
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