IMPACT OF DEMONETIZATION ON

INDIAN ECONOMY
Done by:
Perli. Aryan Nageswararao
ROLLNO: 21CSE1024

INTRODUCTION:
Demonetisation refers to withdrawing a coin or a currency from its use as legal tender.
The current money is pulled from circulation and is often replaced by new notes or
coins. Demonetisation is carried out when a country wants to replace its old currency
with a new one.
The latest demonetization took place on November 8th, year [Link] main objective of
the demonetization was to bring out the money that was procured by illegal businesses
or illegal activities. And also, to bring out fake money which was the main source of
cash used for criminal activities. And also, to invalidate the Indian currency in the hands
of terrorist organisations. And majorly to bring out all the money that was hidden in
secret places to avoid paying taxes.
Our Prime Minister Narendra Modi announced the demonetization of existing notes of
Rs 500 and Rs 1000 during a televised address on Tuesday evening. Modi announced
that the notes of Rs 500 and Rs 1000 "will not be legal tender from midnight tonight"
and these will be "just worthless pieces of paper. PM also urged people to join this
mahayajna against the ills of corruption. In an effort to combat corruption, tax evasion
and counterfeiting, all 500- and 1,000-rupee banknotes are no longer recognized as
legal tender. Electronic payment systems are convenient, fast and easy, but when a
government imposes this decision on you, your economic liberty is debased. In a purely
electronic system, every financial transaction is not only charged a fee but can also be
tracked and monitored. Taxes can‘t be levied on emergency cash that‘s buried in the
backyard. Central banks could drop rates below zero, essentially forcing you to spend
your money or else watch it rapidly lose value.
India had an experience of demonetization of its currency twice before. The first was
when Rs. 1000, Rs. 5000 and Rs 10000 notes were taken out of circulation on 12th
January 1946, a 1 ½ year before the Independence. The highest denomination note ever
printed by RBI in India was Rs. 10000 note introduced for the first time in the year 1938.
However all three of Rs. 1000, Rs 5000 and Rs. 10000 notes were again reintroduced in
1954. The second phase of demonetization was done on 16th January 1978 when an
ordinance was promulgated to phase out notes with denomination of Rs. 1000, Rs
5000 and Rs. 10000. On 12th January 1946 demonetization was resorted to but the
Direct Tax Enquiry Committee in its interim report observed, “Demonetization was not
successful then, because only a very small proportion of total notes in circulation were
demonetized in 1946 and its worth was Rs. 1,235.93 crores”. On 16th January 1978,
demonetization of high denomination notes was introduced. The high demonetization
notes as on that day amounted to Rs. 146 crore and total notes tendered to RBI
amounted to Rs. 125 crores as per data available till August 1981.
The latest demonetization took place on November 8th, year 2016. Our prime minister
Narendra Modi had demonetized the 500-rs and the 1000-rs notes in order to bring out
the black money that was obtained by illegal businesses. this money was not taxed and
was also called as “black money” or “dirty money”. About 99.30% of the demonetized
money was brought back that is approximately 15.41 lakh crores. and about 10,720
cores of money was not brought back.

THE NEED FOR RESEARCH:

The sudden banning of 500 and 1000 RS notes in India has affected all the citizens of
the country severely. Many had no cash in their hands to make day to day purchases as
India was a purely cash based society. And procuring of cash was nearly impossible
and the only notes that were in circulation were found were 2000RS note. With which
the purchase of day-to-day goods was hard as there was no cash to give change.
But also a lot of black money was brought into the society for the benefit of the poor.
And overall growth and development of our society.
As a citizen of India we must understand the reason for the demonetization And its
importance to fully appreciate the significance of this policy.

OBJECTIVE:
To learn and gain a deep knowledge on the 2016 demonetization of India.
Understanding the causes for implementation. Observing its negative and positive
effect on the economy. Its effect on industrial sector and banking sector.

CONTENTS:
• THE ADVANTAGES OF DEMONETIZATION
• DISASVANTAGES OF DEMONETIZATION
• IMPACT ON BANKS DUE TO DEMONETIZATION
 • IMPACTS OF DEMONETIZATION ON SMALL SCALE
INDUSTRIES
• IMPACT ON DEMONETIZATION ON INDIAN ECONOMY
[THEORITICAL ANALYSIS]

THE ADVANTAGES OF DEMONETIZATION:

1) Increases Deposits with the Banks:

The act of demonetization has an effect on people's inclination to hoard physical

currency at home, as the withdrawal of legal tender status for certain banknotes
creates obstacles for individuals looking to exchange their money for the newly
issued currency at banks. This results in a rise in the amount of funds held by
banks, as people refrain from keeping cash in their homes and, as a result, increase
liquidity.
2). Improves Currency Circular

As a consequence of demonetization, individuals deposit their physical cash in banks in

exchange for valid currency. This process facilitates the removal of all cash that was
previously stockpiled at home and out of circulation. The continuous circulation of
currency is crucial for a robust economy, as it reduces the government's burden to print
new notes and incur additional expenses.

2) Helps in Contouring Counterfeit Currency:

Demonetization offers a significant benefit in that it effectively eliminates the

counterfeit currency market. By rendering legal tender obsolete, the use of fake
printed currency is also eradicated. This represents a significant setback for the
counterfeit currency industry, and governments often resort to such measures when
the proliferation of fake notes becomes widespread in their country.

3) Helpful in Tracing Black Money:

The primary rationale behind demonetization is to combat the issue of illicit or

undeclared funds. By rendering old currency void, any physical cash hoarded by
corrupt individuals loses its value since it cannot be exchanged at banks. This
renders the hoarded "black money" useless, serving as a powerful deterrent to
those engaged in such illicit activities.

5) Downside Movement of Lending Rates

Home Loan Rates (Pre and Post Demonetization)

Demonetization has a positive impact on both the circulation of money and banks'
deposit base, which, in turn, helps to lower lending rates. With increased liquidity at
their disposal, banks are better equipped to lend more to businesses. This, in turn,
leads to the growth of infrastructure activities and creates new growth opportunities.

6) Helps in Countering Illegal Activities

Demonetization brings to a halt the circulation of existing currency, which has a

significant impact on illegal activities such as hawala and terror financing. By stripping
the legal tender status of the currency, any existing cash used for financing such
criminal operations is rendered useless, thereby putting a brake on their activities. As
such, demonetization is a vital tool in the fight against such illicit activities.

DISASVANTAGES OF DEMONETIZATION:
1) Causes Panic Among the Public
The cancellation of legal tender for existing currency can be distressing news for the
general public. It can create chaos and panic regarding their hard-earned money. The
process of exchanging invalid currency notes can also be an arduous and painful
experience for people. These inconveniences are some of the common challenges
faced by the public during the demonetization process.

2) Halt in the Economic Development

Demonetization causes a disruption in the monetary circulation of a country, leading to
difficulties in carrying out physical monetary transactions due to the cancellation of
existing currency. This can pose transactional challenges and hinder the smooth flow
of business and economic activities for a period of time, resulting in a temporary
standstill in the country's economic growth.
3) Recalibration of ATMs
During the process of demonetization, the government invalidates existing currency
and introduces a new currency, which creates a need for the recalibration of ATMs.
Recalibration involves modifying the ATMs to accommodate the newly issued notes
and removing any pre-existing systems to enable the dispensing of the new notes
without errors. Recalibrating all ATMs in the country poses a significant challenge for
the authorities.
4) Causes Liquidity Crunch

Invalidating existing currency and an insufficient supply of newly issued currency can
create a liquidity crisis in the market. This, in turn, can hinder economic activities and
adversely impact the daily lives of the general public. In countries where digital
transactions are not widely accepted, the shortage of liquidity becomes a significant
issue since people can only purchase goods and services with the money they have in
their bank accounts. As such, a liquidity crisis is a major concern for both the public
and the government during the process of demonetization..

5) Short-term Downfall in the GDP

A country that chooses to implement demonetization may experience a temporary

downside in its GDP. This is typically due to the disruption of financial positions in
businesses and economic activities, which can destabilize the growth vehicle in the
financial sector. However, over time, the economy tends to recover as liquidity is
restored in the market. Hence, even a financially strong country may experience a brief
decline in GDP during the process of demonetization.
6) Payment Crisis
When a country's currency is no longer recognized as legal tender, it can trigger a crisis
in payments. In countries where digital payment systems are not yet prevalent, this can
create problems. Workers are unable to receive their pay, traders are unable to receive
payments, and the retail industry may face operational difficulties due to the lack of
physical cash in circulation. This can disrupt all types of monetary transactions, ranging
from bill payments to retail sales.

IMPACT ON BANKS DUE TO DEMONETIZATION:

• The implementation of demonetization led to a decline in currency in circulation

and a subsequent surge in bank deposits.
• The total currency in circulation decreased by approximately ₹8,800 billion (₹8.8
lakh crores), which resulted in a sharp increase of around ₹6,720 billion (₹6.72
lakh crores) in aggregate deposits of the banking system, even after outflows in
NRI deposits during the same period.
• Between the end of December 2016 and early March 2017, there was a net
increase in currency in circulation by approximately ₹2,600 billion. During this
period, deposits with banks also declined moderately.
• As per the data for October 28, 2016 (before demonetization) and February 17,
2017 (latest available), aggregate deposits of SCBs (scheduled commercial
banks) increased by ₹5,549 billion during the period.

• Most of the deposits mobilized by SCBs were invested in reverse repos of various
tenors with the RBI and cash management bills (CMBs) issued under the Market
Stabilisation Scheme.
• Loans and advances extended by banks increased by ₹1,008 billion, and the
incremental credit deposit ratio for the period was only 18.2%.
• The additional deposits mobilized by commercial banks were primarily deployed
in liquid assets due to the expected transitory nature of the bulk of such deposits
and weak demand reflected in the subdued growth of credit.
• Banks' net profits essentially reflect the difference between interest earned on
loans and advances and investments and interest paid on deposits and
borrowings, adjusted for operating costs and provisions.
 • After the sharp rise in deposits post-demonetization, banks started lending such
surplus deposits to the RBI under the reverse repo options. PSU Banks,
particularly, deployed excess funds in government bonds, which is likely to add a
15 to 20% increase in the earnings of banks.
• Improvement in digital tools and equipment to execute bank transactions has
helped avoid cash loss due to reasons like theft, dacoits, and misappropriations.

IMPACTS OF DEMONETIZATION ON SMALL

SCALE INDUSTRIES:
Digitalisation in practice:

Following the implementation of demonetization, banks began to withdraw cash from

circulation, which led to a shortage of cash and a phenomenon known as cash crunch.
As a result, digital modes of financial transactions emerged as a practical solution to
address the liquidity scarcity in the market. This shift towards digital transactions can
be particularly beneficial for small-scale industries, as it enables them to receive
payments instantly into their bank accounts and pay their employees on time.
Small scale Industries and E-commerce:

Changes in Small & medium enterprises Revenues as a Result of Demonetisation

As a result of the government's "Make in India" initiative and the implementation of

demonetization, even small-scale industries are now registering with e-commerce
platforms. However, those that operate in digital marketing and offer cash-on-delivery
services often face additional costs associated with payment collection and waiting
periods. By adopting online or digital payment methods, these businesses can
overcome these challenges and experience growth in the wake of demonetization.
Small scale industries and demonetisation:
Due to the implementation of demonetisation, small scale industries were totally ruined
and vanished from the market. These industries required free flow of cash / liquidity of
funds to run their business smoothly and to achieve their daily target.

The Effects of Demonetisation on Different Industries

Industries suffered from great loss :
Small businesses had to restrict their business activities and many of the small
businesses undergone great losses with the demonetisation process. As the Daily
business activities were based on cash transaction like purchase of material, wages,
labour, transport extra.

IMPACT ON DEMONETIZATION ON INDIAN

ECONOMY [THEORITICAL ANALYSIS]:
Money Market Equilibrium
Let's start by assuming that the overall price level or GDP deflator (P) remains
constant. The nominal money supply (M) can be defined as the sum of currency (CU)
and bank deposits (D), where the proportion of money held as currency is represented
by c and the proportion held as deposits is (1-c), such that:
M = CU + D = cM + (1 - c)M
We will assume that the propensity to transact in cash (c) is not significantly impacted
by demonetization, as the banking system has yet to reach many rural areas.

Before demonetization, the value of assets in each account was equal to the value of
liabilities, as shown in the equation:
BR + O = RC + CU + Rg ...(1)
where RC + Rg = R = total reserves.

The government announced a time limit by which the public was required to deposit
their ₹500 and ₹1,000 notes with approved authorities. As a result, D increased as
notes were deposited, but it also decreased due to cash withdrawals, which were
limited to an upper limit W (where W < N). Consequently, Rc increased more than D in
the aggregate commercial banks’ account.

The government later absorbed the excess liquidity in the banking system by raising
the ceiling on its bond holdings under the market stabilization scheme. However, the
actual value of black money in circulation, represented by a certain sum V (for
"vanished"), fell short of the government's estimate. Assuming V > 0, the RBI's liabilities
would add up to Rc + ΔRc + CU - ΔCU - V + Rg = Rc + CU + Rg - V < BR + O ...(2)

Therefore, there would be a fall in the money supply, even if the money multiplier
remains unchanged (unless V = 0). This would impact the equilibrium of the money
market, where the demand for money is a function of real money (MP), aggregate
output (Y), and the nominal interest rate on government bonds (i). With a smaller
money supply, the change in the equilibrium value of i can be expressed as:
M = CU + D = cM + (1 - c)M

The basic macroeconomic rationale for increasing interest rates is as follows: At the
previous equilibrium interest rate, there is a shortage of money, given the decline in the
money supply. This prompts financial institutions, such as commercial banks, to sell
government bonds, causing bond prices pB to drop and i to rise.

This effect on the LM curve is shown in Figure 2, where it shifts upward from LM1 to
LM2 at each Y value. However, it is important to note that the magnitude of this shift
may not be significant if the final value of V turns out to be insignificant. This concludes
our discussion on how demonetisation has affected the money market.
Goods Market Equilibrium

The equation that typically captures the goods market equilibrium is Y = C(Y) + I(i) + G.
However, we propose to modify the consumption function in four ways. Firstly, we will
make it inversely related to ib, which represents the interest rate on bank loans. A
decrease in ib is expected to increase the demand for durable consumer goods such as
cars, although the role of housing loans is unclear due to government monitoring of
real estate transactions. The investment function will also be affected by ib instead of i,
although it is uncertain how elastic I is to changes in ib. For the sake of capturing a risk
premium associated with lending to parties other than the government, we assume that
ib = i + ρ, where ρ > 0.

The second variable that we propose to introduce into the consumption function is an
index that represents the ease of carrying out transactions. The third variable is
consumer confidence, as the government's warnings of harsher penalties can
discourage spending. This variable might also affect investment. Finally, the fourth
variable we suggest incorporating into the consumption function is a Patinkin (1965)
type real balance effect, which represents the positive impact of wealth on expenditure.
We denote the total wealth relevant for the consumption function as W, of which V is a
part. Taking these changes into account, the goods market equilibrium equation can be
written as Y = C(Y, i + ρ, e, φ, W) + I(i + ρ, e) + G.
IS–LM Equilibrium:

Typically, a decrease in the money supply would result in an increase in the sovereign
interest rate. However, the rate has decreased instead, likely due to a significant decline
in activity in the real sector. This shift is indicated by the leftward movement of the IS
curve, caused by changes in e, φ, and a fall in W, which led to a reduction in aggregate
output from Y1 to Y2. This provides theoretical support for Manmohan Singh's quoted
perspective, which argues that the fall in interest rate resulted from the drop in output.
Essentially, the demand curve for money in Figure 1 has likely moved left, reversing the
initial interest rate rise caused by the reduction in the money supply. It is noteworthy
that the Government of India had been urging the RBI to cut interest rates to boost
demand and output. While the demonetisation exercise did lower the interest rate, it did
so for the wrong reason - the decrease in output rather than any intervention.
Furthermore, the fall in output level may be linked to a drop in the GDP growth rate for
the third quarter (October-December) and possibly even the fourth quarter of the
present financial year.

CONCLUSION:
Demonetization has affected us very badly for a short period of time. All the banks,
industries (either small or large scale) were badly affected. Most of the small-scale
industries were closed down because of following only cash-based business model
and not being able to scale to provide delivery services and facility to do online
transactions. But those who adopted to the changes have grown exponentially. And
most of the illegal businesses have been compromised due to lack of physical cash
flow which is their main mode of payment. And most of the money which was withheld
by the people without paying taxes was brought to the surface and all the money taxed
and the lakhs of crores of taxes were used in the development of small scall industries
and for the welfare of the poor. And we have potentially saved the country from anti
nationalists or terrorists whose mode of (payment was cash mainly 500 and 1000 RS
notes). And we have made many Indians adopt to the growing economy by adopting
online transactions which in turn have also increased foreign trade (that is citizens are
buying more foreign goods via online transactions).and one of the major achievement
was the retrieval of money withheld in the Swiss bank which was stagnated by some
wealthy people. Overall, in my opinion the demonetization of 500 and 1000RS noted
was highly beneficial to the Indian economy.

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[2]. Reserve Bank of India
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