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I do not wish to get into the details of the Demonetisation implemented by the Indian Government on 8th November, 2016. Endless political debates have already been conducted advocating or berating this step. As an Economics student, I would like to get some technical insight into this action and the economic effects of demonetization in general.

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  • $\begingroup$ Stack Exchange is not for general essay prompts. Unless you edit this to be a specific question, it will likely be closed. $\endgroup$ – Acccumulation Nov 13 '18 at 15:58
  • $\begingroup$ It is a fairly technical question. It discusses what happens when you pull all the liquidity out of the economy it actually tested the Keynesian thought that money is not neutral. $\endgroup$ – DrStrangeLove Nov 14 '18 at 3:06
  • $\begingroup$ @goodbookandcoffee Yes. This is the kind of insight I needed. I wanted to know about some underlying theories in Economics that support such a seemingly bizarre action. $\endgroup$ – S.Rana Nov 14 '18 at 4:12
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I am not an expert in biology but let me give you some intuition through it.

For instance if you have some impurities in your blood. There are two ways to remove that impure blood from your body.

1) To give you some medicine that enters your system to cure you. This is a slow procedure and may not guarantee concrete results.

2) To artificially suck entire blood out of your body and make attempts to purify it and then refill it into your body. This is a fast procedure and will produce certain concrete results which can either be positive or negative.

Now, if the second method seems lucrative to you, make sure you think of what will happen to you in that time interval when your body is without blood.

Noe let us come to Economics.

Money is a medium of exchange and store of value.

Let me write a simple equation of money.

$MV = PY$

$M$ ~ Amount of money in circulation.

$V$ ~ Velocity of Money. Velocity of money is nothing but number of times the nominal money is changing hands

$P$ ~ Price level

$Y$ ~ Output in the economy

$PY$ hence is the value of output or GDP.

You can make an intuitive sense of this equation that is the GDP of the country is how fast a given quantity of money circulates in the economy. Suppose the GDP (aggregate expenditure) of a country is \$1,000. The amount of money in circulation is \$500. So money should change hands two times for expenditure worth \$1000 to occur which makes velocity of money = 2.

Now once you have digested this relationship. Demonetisation in the Republic of India was not an attack on the quantity of money but on the velocity of money in circulation.

It did not make the existing money worthless since the old cash could be exchanged for new cash but it choked off the flow of money that is the velocity of money in the economy since old cash which made for 86% of the entire money supply ceased to be a legal tender. Now coming back to our equation:

$MV = PY$

There was an artificial decrease in velocity(V) so the right hand side of the equation $PY$ must fall to maintain the equilibrium. That is GDP must fall temporarily which is the stagnation of the economy.

Understand it this way, you temporarily decrease the purchasing power of the people by pulling all the money out of the system. People stop buying stuff and sellers cannot sell their stuff. Producers will stop producing and people will lose jobs. Hence this is an artificially created recession.

This was perfectly evident in the growth rate of the country that slumped by about 2% in the beggining of 2017. The 2% of India's GDP is a phenomenal multi billions of dollars which India lost and which is the actual monetary cost of this decision.

Now the fundamental question at the heart of economic decisions - Does the benefits justify the costs? Which is a debatable topic as you mentioned so I am not going into that.

But what I personally believe is, Indians should have thought it out more rigorously and thoroughly before making such an unconventional move.

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