Any economy across the world is based on 2 basic activities, that is, ‘Production’ and ‘Consumption’. Every government ensures that this cycle runs well, like a human heart, pumping blood to the length and breadth of the body, any hindrance will have dire consequences. In the same way, money, goods, and services are like the blood of an economy, in a case of hindrance they give birth to problems like inflation, deflation, stagflation, recession, depression, etc. In order to produce goods or services we need resources; investments, labor, raw materials, machinery, electricity, etc. For consumption we need money, a valid legal tender to make purchases. Hence money is used to pay the price. Price involves elements like cost and profit. In this way, profit becomes the sole purpose of an entrepreneur to start a firm or a business. Profit is the reward of an entrepreneur. This money is either absorbed fully by the entrepreneur or partly invested back into the business. As money can be compared to the lifeblood of economy we should know more about it. After all, we perform a majority of our activities to obtain monetary gain. Money is the least understood thing in the economy.
Let us begin to understand money by asking some fundamental questions.
What is money?
Money is anything that is accepted by the sellers or a debtor in exchange for goods, services or debt. It can be a paper note, pebbles, shells or any commodity through which we can measure the value of the goods and services that a buyer is going to buy. It must possess the basic characteristics of a medium of exchange, a unit of account, store of value and standard of deferred payment. Mostly all kind of money should have the mentioned characteristics.
What kind of money do we use?
Money can be divided into 4 major types:
1.Commodity Money: Shells, Gold, silver, sugar, etc.
2.Fiat Money:, Paper money and coins
3.Fiduciary Money: Promissory notes and cheques
4.Commercial Bank Money: ATM, Cash, credit money, etc. Commercial bank money is created by the commercial banks, which is based on the demand and supply of money in the economy backed by fractional reserve system.
How important is money for the consumer and a producer?
Money is the life blood of an economy. If the supply of money is more than the productivity in the economy, it will result in inflation. An inverse situation will cause deflation. Therefore there should be a correct balance between the supply of money versus the supply of goods. There are many other reasons for such imbalance in the economy. Money is generally used for consumption and saving purpose by a household whereas for a firm it becomes consumption expenditure and investment expenditure. If the flow of money is stopped the economy can come to a standstill. Hence, money is very important for daily transactions.
The central bank of any nation regulates the supply of the money via various tools and instruments. It is also responsible to issue new currency, replace old currencies and other such activities. It makes the decision regarding stripping a currency or demonetize a currency of its status as legal tender, such a step is known as demonetization. A process of removing a currency from general usage and circulation, such an act is demonetization.
In India, The first instance of demonetization was in 1946 and the second in 1978 when an ordinance was promulgated to phase out notes with the denomination of Rs 1,000, Rs 5,000 and Rs 10,000. The highest denomination note ever printed by the Reserve Bank of India was the Rs 10,000 note in 1938 and again in 1954, but were demonetized in January 1946 and again in January 1978, according to RBI data. The Rs 1,000 note made a comeback in November 2000. Rs 500 note came into circulation in October 1987.
In a time where the average income of person was Rs. 500/month, the denomination of Rs. 5,000 and Rs. 10,000 were very large denominations. Even denomination of Rs. 100 was considered very large at that time. This made Indian economy highly inflationary and unstable.
The reason behind demonetization in 1946 & 1978 was the Heavy Inflation. Higher denominations are lethal cause for inflation in the economy. Due to this inflation has increased so high in Zimbabwe that there are denominations on $2Bn. In order to save our country from that, demonetization took place in 1946 & 1978. These were a big failure because people suffered due to lack of media, Communication, and awareness.
Demonetization has also been done in other nations. Below is a short account of demonetization:
Due to chronic hyperinflation in Zimbabwe, the government was at one point printing a currency note with a face value of one hundred trillion dollars. This obviously rendered lesser denominations obsolete, which were taken out of circulation quickly.
Pakistan has decided to phase out all currency notes with old designs. From December 1, all currency notes across denominations will cease to be legal tender in Pakistan. Islamabad has been trying to bring in new designs and security features to its currency. However, its citizens have nearly a year and a half to exchange old notes. The country had earlier demonetised 5 and 500 denomination notes.
In January 1991 under the leadership of Mikhail Gorbachev, the country withdrew 50 and 100 ruble notes from circulation in an attempt to remove black money and increase the currency value. The removed notes formed around one-third of the total money in circulation.
The large scale demonetization was not successful and Gorbachev faced a coup merely months later in August, however, the 1991 attempt led to a successful redenomination of the ruble in 1998 where 3 zeros were removed, which was followed by another currency switch in 2010 when 2 more zeros were removed from the old currency. The 2010 attempt was not as successful as the timing coincided with a poor harvest.
In the early 1990s, the Dictator Mobutu Sese Seko administration rolled out successive currency reforms along with a plan to withdraw obsolescent currency from the system in 1993. The successive reforms resulted in increasing economic disruptions until Mobutu was ousted in 1997.
The military invalidated nearly 80 percent of the value of money in circulation in 1987, in an attempt to curb the black market. The action triggered the first student demonstration in years before a government crackdown came into effect the next year.
In 1996, Australia became the first country to have a full series of circulating polymer banknotes after replacing all paper-based notes, which the government systemically made non-tender for legal purposes. To stop widespread counterfeiting, the Reserve Bank of Australia had released the world's first long lasting and counterfeit-resistant polymer (plastic) banknotes.
In 1982, the country demonetised its 50 cedi currency note to reduce tax evasion, address corruption, and clear excess liquidity, however, the move resulted in the public turning to foreign currency and physical assets. The general public lost confidence in the banking system and a fresh black market for currency began.
The military government led by Muhammadu Buhari conducted an anti-corruption crackdown in 1984, issuing new currency notes with new colors so that old notes would be rendered unusable within a limited time frame. The goal had been to fix a debt-ridden and inflated economy but was not successful.
On 8th November 2016, the Indian government decided to demonetize the 500 and 1000 Rupees notes. In the exchange of which government is issuing 100 Rupees and 2000 Rupees notes to the public.
Experts have predicted that there will be a likely dip in economic activities till the month of January 2017 because of disruption. It is said that all the big fish who have amassed huge wealth by tax evasion income are either converted into real estate, gold, assets abroad and other real assets. A relatively small portion is held as cash to finance the black transactions. This portion is the target of demonetization. Further the effects can be categorized in the below form:
1. Effect on parallel economy:
The removal of these 500 and 1000 notes and replacement of the same with new 500 and 2000 Rupee Notes is expected to - remove black money from the economy as they will be blocked since the owners will not be in a position to deposit the same in the banks, - temporarily stall the circulation of large volume of counterfeit currency and - curb the funding for anti-social elements like smuggling, terrorism, espionage, etc.
2. Effect on Money Supply
With the older 500 and 1000 Rupees notes being scrapped, until the new 500 and 2000 Rupees notes get widely circulated in the market, money supply is expected to reduce in the short run. To the extent that black money (which is not counterfeit) does not re-enter the system, reserve money, and hence money supply will decrease permanently. However gradually as the new notes get circulated in the market and the mismatch gets corrected, the money supply will pick up.
3. Effect on Demand
The overall demand is expected to be affected to an extent. The demand in following areas is to be impacted particularly:
- Consumer goods
- Real Estate and Property
- Gold and luxury goods
- Automobiles (only to a certain limit)
All these mentioned sectors are expected to face certain moderation in demand from the consumer side, owing to the significant amount of cash transactions involved in these sectors.
4. Effect on Prices
The price level is expected to be lowered due to moderation from the demand side. This demand-driven fall in prices could be understood as follows:
· Consumer goods: Prices are expected to fall only marginally due to moderation in demand as a use of cards and cheques would compensate for some purchases.
· Real Estate and Property: Prices in this sector are largely expected to fall, especially for sales of properties where the major part of the transaction is cash based, rather than based on banks transfer or cheque transactions. In the medium term, however, the prices in this sector could regain some levels as developers rebalance their prices (probably charging more on cheque payment).
5. Effect on various economic entities:
With cash transaction lowering in the short run until the new notes are spread widely into circulation, certain sections of the society could face short-term disruptions in the facilitation of their transactions. These sections are:
- Agriculture and related sector
- Small traders
- Services Sector
- Political Parties
- Professionals like doctor, carpenter, utility service providers, etc.
- Retail outlets
The nature, frequency, and amount of the commercial transactions involved with these sections of the economy necessitate cash transactions on more frequent basis. Thus, these segments are expected to have the most significant impact post this demonetization process and the introduction of new notes in circulation.
6. Effect on GDP:
The GDP formation could be impacted by this measure, with a reduction in the consumption demand. However, with the recent rise in festival demand is expected to offset this fall in overall impact. Moreover, this expected impact on GDP may not be significant as some of this demand will only be deferred and re-enter the stream once the cash situation becomes normal.
7. Effect on Banks:
As directed by the Government, the 500 and 1000 Rupee notes which now cease to be legal tender are to be deposited or exchanged in banks (subject to certain limits). This will automatically lead to more amounts being deposited in Savings and Current Account of commercial banks. This, in turn, will enhance the liquidity position of the banks, which can be utilized further for lending purposes. However, to the extent that households have held on to these funds for emergency purposes, there would be withdrawals at the second stage.
8. Effect on Online Transactions and alternative modes of payment:
With cash transactions facing a reduction, alternative forms of payment will see a surge in demand. Digital transaction systems, E-wallets and apps, online transactions using E-banking, usage of Plastic money (Debit and Credit Cards), etc. will definitely see a substantial increase in demand. This should eventually lead to the strengthening of such systems and the infrastructure required.
According to the statistics provided by the banks, State Bank of India has collected 1,14,139 Crore rupees in 7 days after the announcement by the PM. As per the Government, banks have collected 4 Lakh Crore rupees till now.
I tried my best, to sum up, the entire demonetization subject in the best way I can. I hope you enjoyed reading it. I thank you for taking time out and reading it.