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The Economic and Financial Effect of Demonetization

Due to technological advances, it has become easier to process payments without the use of paper currency. From PayPal to Venmo to Apple Pay, more transactions—both business and personal—are done electronically than in the past. As of 2015, 32% of all transactions in the U.S. were made using cash and 11% were made electronically. Taking into account the value of transactions, electronic payments made up 35% of the total value spent while cash only constituted 9%, indicating that cash is used in a large number of small transactions. Alternative forms of currency that are not tied to any country’s legal tender, including Bitcoin and other cryptocurrencies, have also become increasingly popular. The U.S. has not shown signs of doing away with paper currency. However, it is imperative to formulate policies now aimed at this burgeoning new form of currency before central bankers and governments are left helpless in a virtual flood.

Demonetization is the process of removing currency from the monetary system by either ending its status as legal tender—meaning banks and businesses do not have to accept it—or simply ceasing to print the currency but still accepting it. For example, the U.S. ceased production of bills greater than $100 during World War II, and though they are still accepted as legal tender, they are not recirculated after banks accept them. In 2016, India demonetized their highest bills and replaced them with new bills. All such currency needed to be deposited in banks or exchanged for the new bills within 50 days or it would become worthless. There are many reasons to demonetize, including addressing inflation, combating black markets, and stimulating the economy.

Demonetization

 

Demonetization can reduce inflation by removing money from the market, including counterfeit money or bills that fail to get converted on time, and therefore reducing demand for goods and services. Zimbabwe demonetized in 2009 to address rampant hyperinflation. Additionally, the government allowed Zimbabweans to use foreign currency to conduct business for the first time because their own currency’s value was decreasing faster than prices could adjust. Last year, Venezuela announced the demonetization of their highest bills and the plan to replace them with even larger bills that would keep up with increasing prices; instead of changing inflation’s course, this policy would hopefully make transactions easier because Venezuelans would not have to cart loads of bills to conduct business.

Demonetization can also be a tool to combat black markets and tax evasion. India’s central bank claimed that their demonetization was in part motivated to stop terrorist activity that was funded by counterfeit currency. Several other countries have recently considered dropping some of their paper currency or adding new forms of currency to curtail black market exchanges, including Australia, Venezuela, and Japan.

Another potential benefit from demonetization is a wider array of tools to stimulate the economy. If people hoard large amounts of cash, that money is neither contributing to the economy through spending or through saving, which is important for investment. By forcing that cash to be converted, it has a higher chance of being saved in a bank or being spent. Governments are further frustrated by lost tax revenue. Flushing the cash into the marketplace allows taxes to be levied and collected on those transactions.

Additionally, monetary policy could gain new tools to address economic downturns if all currency was demonetized. Because no money would be stored as cash, banks could charge a fee to store money rather than paying interest, which would in effect be a negative interest rate. For example, Japan kept its central bank rate in the red for several quarters, hoping this would encourage spending much like any other decrease in interest rates. During the recovery from the 2008-2009 recession, the Federal Reserve reached a “zero lower bound” below which the federal funds rate could not drop because banks do not charge negative interest rates, and they had to turn to quantitative easing to boost the economy since they could not slash interest rates any further. Even if only the largest bills were demonetized, it may be possible to have negative interest because it would become difficult to hold money in small bills only; conversely, this could hurt the economy if spenders decided to keep all of their money and conduct all of their transactions with only small bills.

The economic effects touch on some of the many costs to consider with demonetization; the primary concern is about transaction costs at the initial stage of demonetization. A well-planned conversion can reduce transition costs by leaving a long period of exchanges. For example, when the Euro was introduced in the European Union, old currency such as the Deutsche Mark was still convertible to the Euro from 1999 to 2002. In contrast, India’s conversion of cash took place in a short window and had high transition costs. Since most Indians held all of their money in cash, there were long lines to exchange their notes and there were losses to productivity and general unrest, especially in rural areas, during this transition.

Although demonetization is often designed to reduce instability, it can cause instability itself. Although Venezuela demonetized their highest bills last year and replaced them with higher bills earlier this year, hyperinflation is still rampant and the new bills have not kept up with the pace of inflation. The transition was marked by uncertainty and distrust of the government and the currency’s value. Demonetization’s destabilizing effects on financial markets can perhaps be seen most clearly through the economic effects of demonetization.

 

Gross Domestic Savings

 

Introducing negative interest rates would reduce investment in markets if people were able to pull their money out of banks and store it in cash or convert it to another currency, such as Bitcoin. An economy with less investment has fewer opportunities for businesses to start or expand because of their limited access to funds for loans. Additionally, financial markets do not respond well to uncertainty in monetary policy since models are built on expected interest rates. However, converting to a digital currency could increase the amount of data that financial markets have access to and thereby improve their models—provided that the chosen currencies are easy to track.

Despite its good intentions, demonetization may not successfully address inflation, black markets, or economic downturns. Venezuela and India’s recent policy changes have yet to prove successful. Instead of being stopped by demonetization, black markets can turn to other currencies or digital transactions that can be difficult to trace or regulate. Negative interest rates could prove to be a costly policy decision that central banks would rather avoid than use as a tool. In the wake of bailing out big banks in 2009, policy moves that help banks and hurt citizens are less politically viable.

It’s worth noting that cash is a useful medium of exchange that does not rely on technology. Although it’s easy to use an app to send money to friends, coworkers, or roommates, access to a smartphone should not be a requirement for these or other transactions. Some economies could benefit from using more electronic payments, since they can easily be tracked and taxed. For example, to discourage the use of cash Japan recently announced their plans to introduce a new digital currency that can be used instead of yen. Demonetization can be a useful tool to address major systemic problems, but such a drastic step should not be seen as necessary for healthy economies.

In the U.S., the biggest reason to demonetize would be to give the Federal Reserve a new tool to address major recessions, although this may require a complete conversion from cash to a digital dollar. Quantitative easing continues to affect the economy in this long recovery, and it remains unclear whether using it again would be an effective strategy in another large recession or if more flexibility in setting interest rates would be necessary.

However, while problems with inflation and counterfeiting remain small, there is no pressing need to demonetize. U.S. dollars are difficult to counterfeit and are often updated with new printing technology. The dollar is still one of only five reserve currencies recognized by the IMF – following the Chinese yuan, Euro, British pound sterling, and the Japanese yen. The dollar is also guaranteed by the U.S. government, making it relatively stable compared to currency in politically unstable nations. The 2008-2009 recession highlights the interconnectedness of the economies and financial markets of the world, and the dollar’s status as the standard for exchange marks its continued importance in the global economy.

 

 


'The Economic and Financial Effect of Demonetization' have 1 comment

  1. October 29, 2017 @ 4:08 pm Rewa

    Hi The article only just touches on uptake of digital and crypto currencies with demonetization. Would be curious to learn if we have evidence for greater uptake and use of digital money as cash in circulation is reduced in the economy. Secondarily for India there are interesting resources on the impacts on demonetization on the informal sector which is an area future articles could also look into.

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