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November 24, 2016

Currency Reform and the Economic Process

Niranjan Rajadhyaksha, in this Livemint article, discusses some broad issues that deserve immediate attention in the wake of the currency reform. Shedding light on the economic processes that result from this exogenous shock, Rajadhyaksha cautions against jumping to quick conclusions, but to observe how this decision plays out over a longer period of time. Excerpts below:

 

"First, the decision to withdraw old banknotes of high value has disrupted the monetary base in India...

 

Second, what matters in a modern economy based on bank credit is not the monetary base but some measure of broad money, which includes both cash and bank deposits...

 

Third, the stock of broad money in India is more than five times the stock of base money...

 

Fourth, the big problem is that a large part of the Indian economy is still outside the banking system...

 

Fifth, one of the intense debates within monetary economics is on the rather technical question of how money is created...

 

The point is that the currency reform is a game-changer in the true sense of the word. It is quite clear that the immediate impact on the economy will be negative. However, the massive expansion of bank deposits will bloat the contribution of financial services to the increase in gross domestic product in the third quarter, a statistical illusion that could downplay the real impact on economic growth.

 

The real puzzle is what this means in the long run. Much depends on whether this exogenous shock alters citizen behaviour—in terms of whether less cash will be used in the future, whether the tax base will expand as more transactions are done through the formal financial system and if other policy measures restrict the creation of fresh black money."

 

Read the full article here

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