Narendra Modi's outlawing of high-value banknotes last month, aimed at curbing corruption and tax evasion, has left the nation's 1.2 billion population scrambling to exchange old notes for new and left many companies' cash-reliant supply chains in tatters.
India's economy expanded 7.3 percent in the July-September quarter from a year earlier, making it the fastest growing major country in the world. But it could easily lose top spot if some of the more pessimistic views that suggest growth could halve post-demonetization come true.
It could also drag inflation down. At 4.2 percent in October, it is below the central bank's early-2018 target of 5 percent.
Optimistic Impact of Demonetization-
Demonetization creates a way for RBI to enhance economic growth without affecting inflation, thus achieving both objectives.
Suppose, the current money supply (before demonetization) is 1000 crores in the form of 500 & 1000 rupee notes. Out of this, only 900 crores will be deposited in the bank by the deadline time. Rest 100 crores are counterfeit notes or remain unaccounted (thus, loses its value). Thus, money supply goes down by 100 crores.
Low money supply means people have less cash in hand. This will reduce the demand for commodities and hence, prices.
Now, to keep the price at the same level as earlier, RBI needs to bring the money supply at the same level as earlier, right?
How will they do it? They will reduce the interest rate. More people will be encouraged to obtain a loan. Money supply will come back to the initial level. And, thus inflation will come back to somewhat initial level.
Thus, this demonetization will lead to lower interest rates without affecting inflation.
On a broad level, the entire process will shift the money from counterfeit/unaccounted note holder to the people who obtain loans for developing business without affecting the total money supply (and hence inflation). Also, at the same time, the money deposited in banks will jump due to this move. And, thus enable them to provide more loans. Additionally, when banks have more liquidity then they can support our nation in a positive way and will create a positive growth.
Adverse Impact of Demonetization-
India has amongst the highest level of currencies in circulation at 12.1% of GDP. Cash on hand is an estimated at around 3.2% of household assets, higher than investment in equities, or roughly around $ 220 billion. Of this cash, 87% is in the form of Rs 500 and Rs 1,000 notes or roughly Rs 14 lakh crore ($190 billion). Several businesses transact in cash and with demonetization they may become cash-strapped, hurting business—and consequently revenue, employment, consumption and investment. The informal sector in India employs more than a majority of the workers and most transactions are in cash. Disruption to this system could endanger the employment and livelihood of weaker sections of society.
The impact of the demonetization measures would certainly be slower economic growth. As most real-estate transactions entail an element of cash, this market is likely to come to a standstill with property prices likely to fall. This would imply a negative-wealth effect leading to a decline in consumption, and possibly business investment.
Demonetization technically is a liquidity shock; a sudden stop in terms of currency availability. It creates a situation where lack of currencies jams consumption, investment, production, employment, etc. In this context, the exercise may produce following short term/long term/, consumption/investment, welfare/growth impacts on Indian economy. The intensity of demonetization effects clearly depends upon the duration of the liquidity shocks.