A closer look at demonetisation

  • Blog Post Date 13 November, 2016
  • Perspectives
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In this article, Gurbachan Singh contends that black money and white money are simplistic concepts; there is a grey area as well. In his view, the economic effects of demonetisation in terms of real estate, seigniorage, and political funding are complex. The measure can be useful in curbing black money only if supplemented by other policies on a sustained basis.

Black money and white money are simplistic concepts. There is a grey area in a country like India, given the lack of financial inclusion, financial and legal illiteracy, the history of tax laws and foreign exchange regulations, ‘monetary and financial culture’, nature of political funding, availability and use of insider information in the economic and political spheres, and so on. Hence, there is a need for handling matters in a sensitive manner. There is, of course, a need to do something about all the black money, even if parts of it are ‘grey’. The current policy of demonetisation of high-denomination currency notes may be viewed as a step in the direction of adopting a policy of coordination so that the Indian economy shifts from - what economists call - a bad equilibrium to a good equilibrium.

Demonetisation is not sufficient

In 1978, demonetisation was carried out in India but that policy did not end black money. In fact, black money possibly increased over time, thereafter. So this time again the demonetisation announced on 8 November 2016 may not end or even significantly dent black money, unless there are structural reforms in the rest of the economy on a sustained basis to reduce black money. There is a need for stricter collection of taxes and further simplification of tax laws, and reasonable regulations in areas such as real estate, foreign trade, remittances, political donations, mining and gold, so that incentives to deal in black money in the first place are minimised (Acharya et al. 1985, and Government of India, 2012).

To see that demonetisation is not enough to eradicate black money, consider, as an example, the real estate sector. As a result of demonetisation, real estate prices can fall for two reasons. On the demand side, with less black money to support purchases, the demand for property falls and so real estate prices can fall and the quantity can fall. On the supply side, many honest, educated and hard-working people (particularly women) were previously finding it hard to carry out business in this sector. It can be relatively easy now with less black money in circulation. With their greater participation, the sector can become more efficient, productivity rises, supply curve shifts out, prices fall, and the quantity rises. So, while prices can fall due to both demand- and supply-side reasons, the effect on quantity is ambiguous. If it has a tendency to go up, it may face a different hurdle. There is a license-permit raj in real estate; the liberalisation of the 1990s and the Real Estate Development and Regulation Act, 2016 left licensing in the sector untouched (Singh, forthcoming). That may come in the way of expansion of the real estate industry as licenses carry a high price which can only be paid in black money. So, we may be back to square one.

Currency notes in general and high-denomination notes in particular facilitate illegal economic activities, tax evasion, corruption, acts of terror, etc. mainly because these are anonymous. However, there are substitutes for anonymous rupee currency notes – gold coins and bars, and foreign currency notes. This has an interesting implication. If the policy of demonetisation is not suitably supported by other policies and the essence of the black economy stays intact, and there is ‘loss of confidence’ in high-denomination rupee notes due to demonetisation, then there can be a shift to the substitutes going forward. That will be a change of form and not substance. It will be a case of much ado about nothing except that the government would have, as shown later, mobilised additional one-time large seigniorage1 at the cost of future seigniorage.

Economic effects

Supposing that demonetisation is supplemented by other policies and black money indeed comes down, then the demand for currency as a proportion of the demand for money is expected to come down (and the role of bank money should go up). This will,in the long run,lower the path of future seigniorage for the RBI (Reserve Bank of India)/Government of India (GOI). However, there is another effect of demonetisation. Though the old currency notes can be exchanged for new ones, some of the old notes will not be returned as that is money which cannot be disclosed to the public authorities. If, say,a quarter of the old high-denomination notes are not returned and if in the short-term the demand for currency stays unchanged, then the RBI will need to issue additional currency to make up for the old currency that went out of circulation. This implies additional seigniorage for the RBI/GOI. The current value of Rs. 500 notes is Rs.7.85 trillion and that of Rs. 1,000 notes is Rs.6.32 trillion – a total of Rs. 14.17 trillion. A quarter of this amount is Rs. 3.54 trillion. This is roughly the amount that can accrue to the RBI/GOI as seigniorage2. This is more than ten times the tax collected by the GOI through the Income Declaration Scheme 2016; the exact amount was Rs. 0.29362 trillion. So, the government can gain considerably and a section ofthe public and political class loses. This is a case of redistribution from the public to the GOI. If the GOI supplements demonetisation with other policies, then the overall possible welfare gain from demonetisation is as follows.

First, a good proportion of the black money tends to be used for consumption and other unproductive activities. So a curb on black money can increase the long-term savings rate in the economy, which can improve economic growth. Also, for a given savings rate, financial savings as a proportion of total savings can increase. This further boosts growth because financial savings tend to be invested more productively compared to non-financial savings that go into assets like gold and real estate. Second, electronic or digital money goes up at the expense of currency, increasing efficiency of the payments system. Third, productivity can rise in the economy as black money falls, ease of doing business improves, and more honest, hard-working and innovative people can enter businesses. This can give a further push to the growth rate.

However, the impact on aggregate corporate profit scan be ambiguous as the ease of doing business and greater competition can dent the long-term path of real aggregate corporate earnings. So, the fundamental values of stocks in the aggregate may not rise (Singh 2016). This does not imply that the short-run effect on aggregate market prices is predictable as sentiment can play a significant role.

Political funding

Unless there is an indirect effect through a change in the political and financial culture in the country, the policy of demonetisation has hardly any direct effect on the nature of political funding. Even when the dust settles down after demonetisation is implemented, political parties can continue to claim that they have received small sums (in high-denomination notes) and then deposit that money in banks. It becomes white money! So, demonetisation,in isolation, cannot greatly change the nature of funding of political parties in India.


  1. Seigniorage is the difference between the value of money and the cost to produce and distribute it.
  2. There is a one-time minor cost of printing new currency notes. According to one estimate, the cost of printing a Rs. 1,000 note and a Rs. 500 note is Rs. 3.17 and Rs. 2.50 respectively.

Further Reading

  • Acharya, Shankar N and associates with contributions by RJ Chelliah (1985), ‘Aspects of Black Economy in India’, National Institute of Public Finance and Policy.
  • Government of India (2012), ‘Black Money: White Paper’, Ministry of Finance, Department of Revenue, Central Board of Direct Taxes, New Delhi, May.
  • Singh, Gurbachan, “Land price, bubbles, and Permit Raj”, Review of Market Integration, Forthcoming.
  • Singh, G (2016), ‘Understanding and dealing with stock market bubbles’, Mimeo.
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