Prime Minister Narendra Modi announced the sudden demonetisation of Rs.500 and Rs.1,000 currency notes on Monday night. The move aims to wipe out black money in the Indian economy. In the short term, it may upset the economic balance in the country. People usually store their ill-gotten wealth in currency notes of a higher denomination. But the demonetisation will force people to deposit money into banks. This will bring more funds into the system. Here is a look at the possible impact on the economy.

First, rural India may see a major impact. People in rural India and urban labourers live in an informal economy. As most of their transactions are in cash, they will feel the pinch of the transition. Second, the demonetisation will have a huge impact on cash-driven sectors. The real estate, jewellery, and agriculture sectors will feel the pinch. The prices of gold, stocks, and commodities are likely to fall. This would even hurt political spending, as elections are due in Punjab and Uttar Pradesh.

There will be short-term inconvenience. But Modi’s drive for a ‘corruption-free nation’ could have a positive outcome. The move is likely to bring more transactions under the tax net. This would boost the government’s tax revenue. On a larger scale, this will have a positive impact on the formal economy over the long run. It will do so by reducing the parallel economy operating in the country.

IMPACT OF SCRAPPING OLD NOTES ON GDP

The higher-denomination notes represent 86% of the currency value in circulation, said the Reserve Bank of India. The withdrawal of these notes could curb illegal money. Besides, it is likely to boost the tax net. So, the tax-to-GDP ratio should improve. However, this could hurt GDP growth, say economists and experts. Rural India is ill-equipped to go cashless. The farm economy, property sector, jewellery business, and many others are cash driven. The unorganised sector contributes more to the country’s GDP. So, the move is likely to have an adverse impact.

Offering a different viewpoint is Finance Minister Arun Jaitley. ‘Demonetisation not only expands the national GDP, it makes it cleaner as well,’ he says. It should limit the inflow of black money into the political system. It would also reduce the inflow into real estate, higher education, and healthcare. It is too early to predict the extent of impact on the GDP. But it is clear that this disruption will have at least a short-term impact on GDP.

IMPACT ON INFLATION

The immediate impact of demonetisation will be heavy deflation. People who have illegal cash will worry about depositing it in the bank. After all, for each transaction, they would have to show the source. This could result in a sharp reduction of the currency circulating in the economy. As the total money supply reduces, there may be no change in the availability of commodities in the market. In this case, the value of money will increase. Besides, people with legal money will deposit it in the banks. This will increase the banks’ liquidity and their capacity to lend. This will lead to inflation. At some point, both deflation and inflation will balance out.

CONCLUSION

This drastic measure to root out black money may bring growth in the formal economy. It would do so by reducing the parallel economy and eventually adding it to the formal economy. All the temporary inconvenience is like to lead to a long-term benefit. The scrapping of notes has created a panic situation. But it should benefit the country’s economy in the long run by ending the circulation of black money.