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An Analysis of the Effects of the Demonetization of the Indian Rupee on India’s Monetary

Policy

To what extent is demonetization more harmful than beneficial to a nation’s monetary policy?

Economics

Word Count: 3979

May 2018 Examination Session

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Tables of Contents

Introduction……………………………………………………………………………..………3-5

Methodology…………………………………………………………………….………………5-6

Economic Theory…………………………...…………………………………………………6-10

Analysis…….………………………………………………………...………………………10-20

Conclusion….………………………………..……………………………………….………20-21

References……………………………………………………………………………………22-24
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§1: Introduction

Cash is used daily throughout the world. But what happens when the government bans

the use of certain banknotes? In India, demonetization of the five hundred and one thousand

Rupee banknotes was established.

The research question for this investigation is: To what extent is demonetization more

harmful than beneficial to a nation’s monetary policy? Through the investigation, I will be

analyzing the effects of the Indian demonetization on India’s monetary policy. The investigation

focuses on the application of Macroeconomics and International Economics concepts on India’s

recent demonetization.The investigation will have a greater emphasis on the macroeconomic

concepts, since Macroeconomics pertains to monetary policy more so than international

economics. Specifically, I will look at the Macroeconomic concepts of inflation, supply of

money, unemployment rates, and the economy. I will also look at International Economics

concepts like exchange rates.

Evaluating the impacts of the demonetization is necessary, as it suggests whether it is

more beneficial than harmful or vice versa. Other nations like Venezuela are already following

India’s bold move of demonetizing banknotes. Determining whether the demonetization is more

beneficial than harmful to a nation’s monetary policy is useful for nations like Venezuela that

face similar issues in their economy and also wish to implement this policy. If results of this

investigation demonstrate that it is more harmful to pursue a policy of demonetization, nations

should avoid demonetizing their banknotes. If results of this investigation demonstrate that it is

more beneficial to pursue a policy of demonetization, nations should consider following India’s

demonetization move.
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Background:

On November 8, 2016 at 10pm, the Indian government announced that Indian Rupee

banknotes of five hundred rupees and one thousand rupees would be demonetized (Rowlatt,

2016). Demonetization is when the government declares certain banknotes of a currency invalid.

In the case of India, the five hundred and one thousand Rupee banknotes were demonetized,

which made up approximately 80% of cash flow (Rowlatt, 2016). After November 10, Indian

citizens had 50 days to turn the banknotes into the Reserve Bank of India or any other bank

(How Will Demonetization Affect Business in India in 2017?, n.d.). After doing so, they obtain

the credit of their cash amounts into their bank accounts. Families were only permitted to receive

credit for up to 10,000 Rupees when they went to the banks to exchange their money (Watson,

2016). Many low income families and cash reliant families were hurt, since they did not have

access to banks (How Will Demonetization Affect Business in India in 2017?, n.d.).

Furthermore, many small businesses were harmed, because they tend to be more cash reliant.

The demonetized currency is considered illegal and India’s citizens are no longer legally

permitted to possess this currency (Watson, 2016).

Rural populations were harmed significantly as a result of the demonetization. Many

farmers relied on only cash transactions, as they did not have access to banks (How Will

Demonetization Affect Business in India in 2017?, n.d.). Because they did not put their money

into banks, they were affected significantly by the demonetization. Local chemists were not

accepting demonetized currency when the demonetization was announced, so those in need of

medicine were not able to purchase their medicine until they exchanged their invalid banknotes

for new banknotes. Foreign holders of the demonetized money were required to either go to India
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and exchange their demonetized currency for the newly issued currency, or send the money

through a family member who could get it exchanged.

Although the demonetization was proposed to help to India’s economy, the

demonetization had more more of a negative impact on India’s monetary policy in the

short run. Despite negatively impacting India’s monetary policy in the short run, the

demonetization proved to be more beneficial than harmful in the long run, making the

policy as a whole more beneficial than harmful.

§2: Methodology

Secondary Sources

The research from my investigation was used from both secondary sources that consist of

website articles, various databases like World Bank, and reports from the Indian government.

The information described in these sources was necessary in order to find research that shows

how the demonetization of the Indian five hundred and one thousand Rupee banknotes affected

India’s monetary policy.

Range of Investigation

The Demonetization occurred on November 8, 2016, so this investigation will focus from

2016 to the end of 2017. This timeframe is sufficient, since it will compare the economic

performance during the demonetization to the economic performance before and after the

demonetization. The time period is appropriate, since it monitors both the long term and short

term effects of the demonetization. The investigation will only focus on the demonetization in

India, as India’s demonetization was somewhat recent. There are a plethora of sources available
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given this range of investigation with sources ranging from newspaper articles, Indian

government documents, and Databases.

§3: Economic Theory

Economics is the study of how firms use limited resources to produce goods that satisfy

the unlimited wants and needs of the citizens (Tragakes, 2012, p. 51). The demonetization of the

five hundred and one thousand Rupee banknotes affects economics in India, since it is an

instance in which the government intervened with the use of Rupee banknotes. This government

intervention affects the supply of Rupees, since it is being reduced. With such a significant

change in the currency, producers will be affected in how they are able to purchase limited goods

to produce the goods that satisfy the unlimited wants and needs of consumers. Furthermore,

consumers will be affected in the way that they purchase these goods, which may affect their

desire towards certain inelastic goods. Specifically, the demonetization in India pertains to both

Macroeconomics and International economics.

Macroeconomics:

Macroeconomics is the way in which the government intervenes in firms’ use of limited

resources to fulfill the unlimited wants and needs of consumers (Tragakes, 2012, p. 79). The

situation pertains to macroeconomics, as the government is intervening in the way in which

consumers use currency as means of purchasing firms’ limited resources to satisfy their own

unlimited wants and needs. By demonetizing the five hundred and one thousand Rupee

Banknotes, the Indian government is altering the way that the citizens use their money and

attempting to address the inefficiencies present inside India’s economy.

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Such a bold move by the Indian government affected a large part of their economy,

specifically, India’s monetary policy. Monetary policy is the macroeconomic policy laid down

by the central bank. It involves management of money supply and interest rates. It is a demand

side policy that the government pursues to achieve macroeconomic objectives like target goals

for inflation, economic growth and liquidity. India’s central bank is the CBI or the Central Bank

of India (Central Bank of India Profile, n.d.). Alongside this bank, India also relies on the RBI or

the Reserve Bank of India (About the Reserve Bank of India, n.d.). Monetary policy is generally

pursued during an economic recession (Maley & Welker, 2011, p. 43).

Graph 1: The Business Cycle

Graph 1: The graph for the business cycle is shown above. Negative slope signifies that the

nation is experiencing a recession, whereas the positive slope signifies a period of economic

growth. Monetary policy is therefore pursued at a time when the slope is negative and when the

nation is experiencing an economic recession. As shown in the graph, a nation can be in a

recession if the potential output is less than equilibrium output. (Business Cycle, 2017).

Generally, the governments strive to reach one of the following macroeconomic goals:

economic growth, low unemployment, low inflation, or equitable distribution of income (Maley
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& Welker, 2011, p. 94). Economic growth is an objective that focuses on achieving potential

output at a stable level. The other objectives all are different goals to achieve potential output.

There are various benefits and weaknesses to pursuing monetary policy. The benefits of

monetary policy include that there are no political constraints, better control on inflation, no

crowding out, it operates quickly, and interest rates can be adjusted incrementally. The

weaknesses of monetary policy are that there is no control, it only impacts loan rates, may

conflict with the objectives that the government wishes to pursue, it can impact the nation’s

central bank, and it cannot be pursued during a time of stagflation, meaning there is high

unemployment and high inflation (Tragakes, 2012, p. 97). Additionally, there are various

weaknesses to monetary policy that include that it may be ineffective during a recession, as the

rates cannot go below zero (Tragakes, 2012, p. 98). Central banks have a critical role in ensuring

the economic stability of a nation with the way in which they pursue monetary policy to achieve

low and stable inflation. Inflation rates are influenced by the supply of money, since increased

money supply causes increased inflation rates. Inflation generally signifies a higher price of

goods.With higher priced goods, people tend to save their money more.

The demonetization in India affected the supply of money and inflation rates,

demonstrating that the monetary policy was affected. Monetary policy specifically involves

deflation, which is when prices for goods are reduced. Deflation is when the inflation rates

decrease. The inflation rates cannot decrease to levels below zero. The government uses

quantitative easing to alter the money supply through the purchases or the sales of bonds.

India’s monetary policy can be influenced by the any of the following: the performance

of the economy, the inflation rates, and the supply of money.

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International Economics:

The demonetization also impacted the exchange rates and the value of the Indian Rupee.

International Economics is the way in international businesses and governments interact to

satisfy the unlimited wants and needs of consumers using limited resources. This relates to the

theory of International Economics, since the Indian Rupee is getting stronger in the long term,

which suggests they can more effectively trade with other nations. The demonetization affects

the supply and demand of the Rupee both internationally and domestically. The exchange rate of

the Indian Rupee is therefore a secondary effect of the demonetization.

Purposes of demonetization:

Narendra Modi proposed the demonetization to address problems of illegal Markets, tax

evasion, counterfeiting, and limiting terrorism and bribery.

Illegal markets are an issue in India, as too many businesses are illegally formed. These

firms avoid putting their money in the banks. Without entry into a bank, the firms illegally avoid

paying taxes, also known as tax evasion (Biswas, 2016). Counterfeiting is the use of fake

banknotes to illegally purchase goods (Tragakes, 2012, p. 73). Counterfeiting causes another

major problem in India: terrorism with the purchase of illegal weapons. Terrorism is a problem

in India’s state of Kashmir, since officers who monitor the borders between India and Pakistan

are often attacked (Biswas, 2016). The illegal markets, tax evasion, and counterfeiting were

major issues in India’s economy that would only grow if not addressed immediately. Modi

therefore believed that the establishment of the demonetization was necessary to ensure the

economic growth and success of India. Although India has not had any notable cases of
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corruption or bribery, the demonetization would prevent such an incident from occurring in the

future.

To address the issue of black markets and tax evasion, demonetization would require the

owners of black markets to exchange their currency for valid currency. If the citizen runs a black

market or keeps to much cash in their home, they would not be able to exchange their old

banknotes for new banknotes, which eliminates illegal markets. Ultimately, the purpose of the

demonetization was to emphasize the need for India to adapt to a digitized economy to monitor

and prevent illegal activities (Watson, 2016). A digitized economy embodies the idea of relying

on the use of banks, where the government can effectively control monetary policy and track the

goods purchased by citizens. This type of economy would reduce the terrorism, as the

government can track purchases of goods that are related to terrorism like weapons. Modi also

hoped that a more digitized economy would be beneficial to measuring the GDP more accurately

(Watson, 2016).

§4: Analysis

Demonetization was proposed to benefit India’s monetary policy in the long term,

however, the demonetization harmed India’s monetary policy in the short term. Since monetary

policy deals with inflation and the supply of money, each of these will be evaluated for their

benefits or their harms that the demonetization resulted in. Other factors like unemployment that

influence monetary policy will be evaluated as well.

Supply of Money:
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Demonetization increases the supply of money into banks, as more Indian citizens are

giving in their money to the reserve bank. Goods became more expensive in India, since the

supply of money increases. Additionally, the increased reliance on a digital economy contributes

to the decrease in the money supply. The graph below demonstrates the change in the supply of

money in India.

Graph 1:

Graph 1: The graph above demonstrates the change in money supply. As a result of the

demonetization, the money supply in banks increases. Money supply in the economy decreases.
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Table 1: Supply of Money in Indian Reserve Bank

Month Supply of Money in RBI (Rupees in

Billions)

December 2016 19865.3

January 2017 121561.0

February 2017 122993.4

Table 1: The table above shows the supply of money in the Reserve Bank of India over time. As

time passed, the supply of money in banks was increased (About the Reserve Bank of India, n.d.).

As shown in graph 1, the original quantity of the supply of money or Sm is shown to be

shifted to the right or to Sm​1​, since the supply of money in banks increases from 12641 Billion

Rupees to 16158 Billion Rupees. Because interest rates and the supply of money are inversely

related, the interest rate decreases as the supply of money increases. The interest rate shift from

R​e ​to R​e1​.

Graph 2:

Graph 2: Monetary base experienced significant decrease at the time of demonetization. This

was only a short term effect, as the monetary base experienced an increase after the

demonetization.
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Inflation:

The Reserve Bank of India uses the consumer price index to accordingly adjust its

inflation rates. The Consumer Price Index is an economic indicator that details the variation of

prices of goods that are paid by consumers. After the demonetization, the RBI targeted to keep

inflation below 5% in India. Inflation rates signify that demonetization was harmful in the short

run in the months of December to March, however, inflation rates were relatively stable in the

long run in the months of April and May. The inflation rates were concerningly high after the

demonetization, demonstrating how it was initially harmful. Over time the inflation rates reached

a stable rate, showing that the demonetization was beneficial in the long run.

Table 2: Inflation in India: Five Months

After Demonetization

Month Inflation Rate

October 2016 3.35 %

November 2016 2.59 %

December 2016 2.23 %

January 2017 1.86 %

February 2017 2.62 %

March 2017 2.61 %

April 2017 2.21 %

May 2017 1.09 %

Table 2: The table above shows the inflation rates in India for each corresponding month. The

inflation is shown for two months before the demonetization and five months after the

demonetization went into effect. (About the Reserve Bank of India, n.d.)
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Unemployment:

Due to the Indian demonetization, unemployment in India actually increased. Tax

evasion and black markets were such a prominent issue in India that businesses could not

exchange all of their money for demonetized money, resulting in lack of money to pay

employees. This type of unemployment is considered structural unemployment, as there is a

mismatch for the demand and supply of labor. As a result of the demonetization, many cash

reliant firms do not have any means to pay their employees (Biswas, 2016).There is a lower

supply of labor, as workers are not willing to work for demonetized or no money at all. During

the week that the demonetization was announced, the week of December 4, the unemployment

rose from 5% the week before to 6.1%. During the week of December 11, the unemployment had

risen to 6.6%, and 7.0% the following week (Unemployment Rate in India, n.d.). As shown in

table 3, this increase in unemployment was only temporary. The unemployment in India after the

demonetization indicates that the demonetization only affected employment in the short run. As

shown in table 3, the unemployment levels decreased in the long run, demonstrating how

demonetization was more beneficial than harmful in the long run.

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Table 3: Unemployment in India:

Six Months After Demonetization

Month Unemployment
Rate

December 2016 6.40 %

January 2017 5.97 %

February 2017 5.06 %

March 2017 4.71 %

April 2017 3.89 %

May 2017 3.98 %

June 2017 3.80 %

Table 3: The table contains the unemployment rates in India for each respective month.

The unemployment decreased after the demonetization. The table shows how the unemployment

changed over a period of six months after the demonetization was put into place. (Unemployment

Rate in India, n.d.)

The supply of money within the RBI was increased (About the Reserve Bank of India,

n.d.). The government reported that approximately 90% of the cash circulation within the

economy was placed back into banks (Gupta, 2016). Since the demonetization has provided the

Reserve Bank of India or RBI with high sums of cash, critics argued that the reserve bank should

reduce interest rates to lower lending rates to consumers. The Indian government, however, has

chosen to keep the interest rates constant (Watson, 2016). By doing so, the government enforces

citizens to spend their money instead of storing it in the bank. The demonetization enforces
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economic growth, because citizens are encouraged to spend their money in case of another

demonetization. Citizens spend their money on goods, initiating the multiplier effect, which

results in further economic growth and increasing India’s GDP.

Since demonetization was proposed to address the issue of tax evasion, the government

would benefit from the demonetization in the long run. The demonetization prevents the Indian

citizens from avoiding paying taxes. So, in the long run, the government will generate more

revenue through the demonetization. This is beneficial to India’s monetary policy, since the

government has money that they can invest accordingly into the performance of the Indian

economy.

Demonetization is also beneficial to India’s monetary policy, as the demonetization

pushes India towards a more digitized economy. A digitized economy would allow for increases

in productivity and efficiency within the Indian economy. Given that efficiency and productivity

are macroeconomic goals that monetary policy strive to achieve, there would be a reduced

chance of India facing a recession.

As a result of the demonetization, India is experiencing a period of stagflation in the short

run where both the unemployment and the inflation are growing at high rates. Pursuing the

monetary policy would be ineffective, since monetary cannot be pursued during a period of

stagflation. The demonetization resulted in a short period of stagflation, which would be so

harmful to the monetary policy that altering the inflation rates in the monetary policy would be

ineffective in influencing the nation out of the recession.

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Graph 3:

Graph 3: The graph above demonstrates the inverse relationship between unemployment and

and inflation. The relationship is true except during a period of stagflation. Since India is

experiencing a period of stagflation, India’s economy is not following this model in the short

run. In the long run, India will follow this model, as unemployment eventually decreased over a

period of six months (Tragakes, 2012, p. 54).

Exchange rates:

After the Indian demonetization, the currency initially became weaker. Foreigners from

other nations want to exchange the Indian currency for other currencies, resulting in the

weakening of the Indian Rupee. After some time after the establishment of the demonetization,
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however, the currency became stronger. The currency reached levels as low as 63.63984 Rupees

equaling one US Dollar (XE Currency Converter, n.d.). The currency experienced a 7.81%

growth in the value of their currency (Shettyl, 2016). The exchange rates are a secondary effect

that impacts India’s monetary policy. The exchange rates were harmed in the short run,

demonstrating how the demonetization was more beneficial than harmful in the long run.

Economy:

The economy impacts India’s monetary policy as secondary effect of the

demonetization. Since the performance of the economy affects India’s monetary policy, the

monetary policy has been harmed in terms of the performance of the economy. Aggregate

demand would decrease as a result of the demonetization. Aggregate demand is given by the

equation below:

AD= C + I + G + (X - M);

where AD is aggregate demand, C is consumer spending, I is investment spending, G is

government spending, X is exports, and M is imports. The number of exports would decrease as

a result of the demonetization, since there was an increase in unemployment. As a result, the

nation would rely on more imports, which decreases the Aggregate demand. Graph 5

demonstrates the change in aggregate demand as a result of the demonetization.

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Graph 5:

Graph 5: As a result of the shift in Aggregate demand, the output decreases from y​e ​ to ye1
​ .​ The

price level also consequently shifts from PL​e ​ to PLe1

​

Modi believes that India has experienced a lack of investment from foreign nations due to

its high poverty and inefficient economy. The demonetization was therefore established to fix

these issues and increase FDI or Foreign Direct Investment into India (Bhagat, 2016). In the

short term after the demonetization, investments from companies or other nations would

decrease due to temporary slowdown in the economic growth in India. Since the demonetization

fixes the issues of poor capitalism and corruption, the investment should increase in the long run

(Singh, 2016). The FDI influences the Aggregate demand positively in the long run. Investment

influences aggregate demand, as shown by the equation for Aggregate demand. The equation

demonstrates that aggregate demand and investment have a direct relationship, meaning that both

values either increase or decrease. Because the economic performance of a nation corresponds to
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that nation’s monetary policy, the demonetization hurt the monetary policy in the short run and

benefited the monetary policy in the long run (Singh, 2016).

§5: Conclusion

Overall, the disadvantages of demonetizing the five hundred and one thousand Rupee

Banknotes exist in the short term and few exist in the long term. Since few weaknesses of

demonetization exist in the long term, the demonetization was largely beneficial to India’s

monetary policy. As a result of the demonetization, the government benefited more so than the

citizens of India. The government was able to create the demonetization to solve many issues

that the Indian economy was facing. Meanwhile, Indian citizens experienced unemployment, loss

of income, and inconvenience. The creation of the demonetization, however, only resulted in

these harmful consequences to be temporary. The economy was able to overcome the obstacles

associated with the demonetization, so the demonetization was more beneficial than harmful in

general to India’s monetary policy.

Inflation rates, the supply of money, and unemployment were macroeconomic concepts

that demonstrated how the Indian demonetization was more beneficial than harmful in the long

run. The economy and exchange rates were secondary effects of the demonetization that

influence monetary policy, and further demonstrate that the demonetization was more beneficial

than harmful due its success in the long term.

Limitations occur with the investigation, as economic activity is difficult to measure

accurately given that the economics of India are constantly changing. As a result, it was

necessary for me to use credible sources that could measure data precisely so that my
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investigation would also be accurate. Another limitation is that the data that I found could have

been skewed slightly, since some Indian citizens were able to cheat the demonetization system

by exceeding the amount of Rupees that they were legally permitted to change for credit.
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§6: References

About the Reserve Bank of India. (n.d.). Retrieved January 16, 2018, from Reserve Bank of

India website: https://rbi.org.in/

Bhagat, N. (2016, November 13). Ban on 500 and 1000 Currency Notes, How it Effects Foreign

Investment in India. Retrieved January 17, 2018, from PR Newswire website:

http://www.prnewswire.com/news-releases/ban-on-500-and-1000-currency-notes-how-it-

effects-foreign-investment-in-india-601072946.html

Biswas, S. (2016, November 14). India rupee ban: Currency move is ‘bad economics’. Retrieved

January 2, 2018, from BBC News website:

http://www.bbc.com/news/world-asia-india-37970965

Business Cycle. (2017). Retrieved January 16, 2018, from Higher Rock Education website:

https://www.higherrockeducation.org/glossary-of-terms/business-cycle

Central Bank of India Profile. (n.d.). Retrieved January 16, 2018, from Central Bank of India

website: https://www.centralbankofindia.co.in/english/home.aspx

Gupta, R. (2016, November 28). Demonetisation effect: Scarcity of cash at foreign exchange

counters as well as ATM’s in the country. Retrieved January 2, 2018, from Times of

India website:

https://timesofindia.indiatimes.com/city/agra/Demonetisation-effect-Scarcity-of-cash-at-f

oreign-exchange-counters-as-well-as-ATMs-in-the-country/articleshow/55669595.cms
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How Will Demonetization Affect Business in India in 2017? [Blog post]. (2017, January 5).

Retrieved from Knowledge @ Wharton website:

http://knowledge.wharton.upenn.edu/article/will-demonetization-affect-business-india-20

17/

Rowlatt, J. (2016, November 14). Why India wiped out 86% of its cash overnight. Retrieved

January 2, 2018, from BBC News website:

http://www.bbc.com/news/world-asia-india-37974423

Shettyl, M. (2016, December 21). Monetary Policy Committee was sanguine on impact of

demonetisation. ​The Times of India​. Retrieved from

http://timesofindia.indiatimes.com/business/india-business/monetary-policy-committee-w

as-sanguine-on-impact-of-demonetisation/articleshow/56108934.cms

Singh, R. (2016, November 19). Real Reason Behind PM Modi’s Demonetization Move!!! [The

Fearless Indian]. Retrieved May 16, 2017, from

https://thefearlessindian.in/real-reason-behind-pm-modis-demonetization-move/

Tragakes, E. (2012). ​Economics for the IB Diploma​ (2nd ed.). Cambridge University Press.

Unemployment Rate in India. (n.d.). Retrieved January 16, 2018, from CMIE website:

https://unemploymentinindia.cmie.com/

Watson, P. W. (2016, December 1). India’s Demonetization Could Be The First Cash Domino

To Fall. Retrieved May 16, 2017, from Forbes website:

https://www.forbes.com/sites/patrickwwatson/2016/12/01/indias-demonetization-could-b

e-the-first-cash-domino-to-fall/#5def233d63db

Welker, J., & Maley, S. (2011). ​Economics​. Pearson baccalaureate.

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XE Currency Converter: USD to INR. (n.d.). Retrieved January 2, 2018, from Xe website:

http://www.xe.com/currencyconverter/convert/?Amount=1&From=USD&To=INR