Demonetization: How it helps IndiaThe How, not the Why

Components of Money SupplyM0 (Reserve money) = Currency in circulation + Bankers’ deposits with the RBI + ‘Other’ deposits with the RBI.

Directly affected.M1 = M0 + Demand deposits in Banks. Directly affected.

M2, M3 and M4 = Not directly affected, affected only via M0 and M1

• Total money supply M0 on 28th Oct 2016 stood at Rs. 17013.8 billion(Source: RBI's press release dated Nov 4, https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=38538 )

• Conservative estimate: 86% of total currency (Rs 14631.9 B) was in 500 and 1000 notes(Source: Table VIII.8, RBI Annual Report 2015-2016, https://www.rbi.org.in/SCRIPTS/AnnualReportPublications.aspx?year=2016 )

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Money supply mechanism• Distribution of notes (M0) throughout the country is done by RBI through designated bank branches, also

called chests

• When money is deposited into chest, it leads to credit of the commercial banks’ account while any withdrawal leads to debit. From economic perspective, • net withdrawal from chests => expansion of currency• deposits into chest => contraction

• Total notes in circulation represents the liability of RBI

• RBI adjusts its asset-liability position for expansion or contraction

How it will happen• All demonetized currency (approx. Rs 14631.9 Billion) now have to be deposited back into chest

• Will lead to contraction as explained

• Following deposits of money, chest will issue equal amount of new denomination to the depositors

• 3 possibilities:• Clean money: No issues, will be exchanged• Hitherto unreported money: Will attract taxes• Bad money: Won’t be deposited

Benefits (& Costs)• Currency in circulation is RBI’s liability to currency holder

• The bad money component of current M0 supply =>wont be deposited into chest => will be cancelled => wont be RBIs liability after 31st March, 2017

• Economy’s gain:• Government gets additional taxes – can be used a fiscal instrument for boosting growth,

infrastructure• Contraction of RBI liability• A portion of black economy will turn mainstream and add to GDP

• Costs: • Temporary inconvenience of public• There is a possibility of a short economic slowdown due to temporary crunch in money supply This is

expected to be a very short, quickly passing phenomenon, if at all. Moreover, Banking system, RBI and Finance Ministry seem to be aware and taking measures to avoid such a situation