Impacts of Demonetization

Impacts of Demonetization on Indian Economy

In a historical decision, Indian Prime Minister Narendra Modi announced that the 500 and 1000 Rs. Notes will not be legal tender from midnight, 8th November 2016.

Impacts of Demonetization on Indian Economy
Impacts of Demonetization on Indian Economy

The RBI will issue 2000 Rs. notes and new notes of 500 Rs. which will be placed in circulation from 11th November 2016.

Impacts of Demonetization on Indian Economy
Impacts of Demonetization on Indian Economy

This action has been taken by the Government of India in an attempt to address the resolve against corruption, black money (that money on which tax is not paid to the government) and counterfeit notes.

Why money earned is concealed from the government?

A major reason for it is illegal trade and crimes. Because people who have illegally earned this money may be afraid to show their income to Government.

Second reason is to evade payment of direct and indirect tax.

 

What are the impacts of Demonetization on Indian Economy?

Demonetization affects the economy through the liquidity side.

On 28 October 2016 the total banknotes in circulation in India was 17.77 trillion (US$260 billion). In terms of value, the annual report of Reserve Bank of India (RBI) of 31 March 2016 stated that total bank notes in circulation valued to 16.42 trillion (US$240 billion) of which nearly 86% (around 14.18 trillion (US$210 billion) were 500 and 1,000 banknotes. In terms of volume, the report stated that 24% (around 22.03 billion) of the total 90266 million banknotes were in circulation.

As a result of the withdrawal of Rs.500 and Rs.1000 notes, there occurred huge gap in the currency composition as after Rs 100; Rs 2000 is the only denomination.

Effectively, this will make Rs 2000 less useful as a transaction currency. It creates a situation where lack of currencies jams, consumption, investment, production, employment etc.

 

Here I highlight the Presumptive consequences of this decision on various economic variables and entities:-

  1. Cash Circumstances:

The 500 and 1,000 rupee notes were the largest denomination of money, which made up for 14 lakh crores in circulation.

Demonetization has a direct impact on sectors dealing with cash—vendors, auto rickshaw drivers, taxi drivers, daily wage earners and small traders.

Even sectors like real estate, which deal with illegal cash transactions, will go through a rough patch leading to fall in profits.

  1. Impact on counterfeit currency:

The impact of it will be on counterfeit/fake currency as its circulation will be checked after this exercise.

  1. Effect on Demand:

The demand in following areas is to be impacted particularly:

  • Consumer goods
  • Real Estate and Property
  • Gold and luxury goods
  • Automobiles (only to a certain limit)
  • Agriculture and related sector
  • Small traders
  • SME
  • Services Sector
  • Households
  • Political Parties
  • Retail outlets
  • Professionals like doctor, carpenter, utility service providers, etc.
  1. Effect on Prices:

Price level is expected to be decreased due to equilibrium from demand side. This expected decreased price level due to equilibrium from demand side can be understood as follows:

  • Consumergoods: Prices are expected not to decreaseat major level due to equilibriumin demand as use of cheques and online payments instead of some purchases in cash.
  • Real Estate: Prices in this sector are expected to decrease at major level, especially for sales of properties where major part of the transaction is cash based.
  1. Effect on Banks Deposits and Interest Rates:

After this announcement of Government of India, peoples have deposited in banks a lot of cash which is legally earned.

Therefore Banks have a lot of cash more than before demonetization.

As a result of this activity, banks will increase the lending activity because banks have a CRR (cash reserve ratio) to maintain and with more deposits they can do more lending.

Credit (loans) will become easier and interest rates may come down.

More loans given out increases broad money supply and creates inflation.

But this will happen slowly, not over-night. 

  1. Effect on Online Transactions and alternative modes of payment:

Demonetization has increased the opportunity for online mode payment with less cash transactions situation.

Thereafter online payment will definitely boost in future.

Online payment is available in the form of Digital transaction systems, E-wallets and apps, online transactions using E-banking, usage of Debit and Credit Cards, etc.

  1. Deflation:

There are many peoples who have earned black money in millions through illegal ways.

People who have illegally earned this money may be afraid to deposit it in a bank.

Most of these guys have wasted the money in rivers, burnt Rs.500 and Rs.1000 notes and stashed in their homes.

This will reduce the total currency circulation in the economy.

Thereafter deflation increases the value of money because the total money supply goes down but the commodities and things available in the market have not gone down.

Thereafter purchasing power of common man will increase.

  1. The tax effect:

Government has announced that cash deposits above 2.5 lakh made between 10th November to 30th December will be kept under scanner from Tax Department.

Any cash deposits above 10 lakhs will be considered a case of tax evasion.

Any mismatch on Income will be liable to 200 % Penalty above income tax as per the Section 270(A) of theIncome Tax Act.

This can help bring black money into the white money fold, making it legal. This can also provide revenues for government, which can be used to pay the deficit in the budget estimation.

If economic activity is slow, then the indirect taxes (tax on goods and services) will be lesser than estimation.

How to Calculate Tax and 200% Penalty on Black Money Deposits:

Assume that the cash deposit of Rs. 20 Lakhs then calculation would be:-

Upto Rs. 2.5 Lakh = Nil

Rs. 2.5 Lakh to Rs. 5 Lakh = 5% of 2,50,000 (Rs.12,500)

Rs. 5 lakh to Rs.10 lakh = 20% of 500000 (Rs.1,00,000)

Above Rs. 10 lakh = 30% of 10,00,000 (Rs. 3,00,000)

 

Hence Total Tax payable in normal circumstances = Rs. 4,12,500 with applicable cess

And

Total tax penalty in case of black money= Rs. 8,25,000 (200% of Rs.4,12,500) with applicable cess

Hence Total tax payable = Rs. 12,37,500 (Rs. 4,12,500+Rs. 8,25,000)  with applicable cess

  1. Effect on GDP (Gross Domestic Product) and Growth:

Though there may be a decrease in consumption due to shortage of cash.

But Growth would not falldue to equilibrium between consumption of high demand and low Prices of goods.

And lending activity by banks at lower rates would also forcibly bring huge amount of money in consumer market.

This will increase the growth rate and therefore GDP would not face a negative impact.

  1. Real estate:

Although the major portion of potential buyers have gone down suddenly. But real estate crash will happen slowly because people will yield to the pressure slowly and start selling at lower prices.

That’s because, in real estate, there is no index price like gold and it is fixed by the market in a demand-supply balance.

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