Updated July 6, 2023
What is Demonetization?
Demonetization is an economic process of removing a currency unit of the legal tender, i.e., the money is pulled out from circulation and has no validity.
For example, the Indian government demonetized the ₹500 and ₹1000 banknotes on April 8, 2016. With an excessive increase in Fake Indian Currency Notes, the government stopped this illegal activity overnight. The act led to an economic disruption that stalled the GDP growth rate as more than 80% of the currency got out of the legal tender.
It is a crucial modus operandi in the economy of the country. In the process, the currency unit becomes worthless and loses its value to purchase. It has to be replaced by new notes and coins of different denominations.
Key Highlights
- Demonetization is a modus operandi in which a country loses its assigned legal tender through the intervention of central banks.
- The primary use is to curb the illegal activity of holding black money that can be trenched back for purposeful activities.
- After the process, the expected inflation rate falls, leading to a consumption crunch.
- The major disadvantage is the rise of issues with minting coins and new currencies.
How Does Demonetization Work?
Demonetization is a process of devaluing the identity of the currency and putting it out of the legal tender. It puts the circulation on hold. Once there is an announcement for Demonetization, the black circulating money automatically gets out of circulation.
The country loses the value of its legal tender, which directly affects consumer transactions and the related circulation of money. This effect comes when a particular country changes its currency implementing policies without impacting its monetary policy changes.
Examples of Demonetization
Example #1
The European government provided banks with new banknotes and coins before introducing the Euro in 2002. They began to mint fiat money in 1998 and delivered it to the banks so that the citizens could access the new fiat money when the Demonetization came into effect.
Example #2
Regarding the USSR, the domination of the 100 and 50 Ruble got out of order. The citizens could exchange the old notes with new ones within a stipulated time. Post that, the citizens have to appear in front of the commissioner to justify their actions.
Reasons for Demonetization
- The implementation of Demonetization is to cease counterfeiting the current fiat currency.
- It is employed to stop criminals from funding terrorism.
- Controlling black money is also another reason for this operation.
- Another reason is to reduce income inequalities among the people of the country.
- A liquidity shock affects the circulation of money, and the impact on the legal tender puts the consumer at pace.
Effects of Demonetization
- The overall demand gets affected to an extent and also impacts Consumer goods, Real Estate and Property, Gold and luxury goods, and Automobiles.
- The price level decreases due to moderation from the demand side. Prices fell due to shrinking demand as the currency circulation is limited for the consumer to take charge.
- With notes getting scrapped until the new denominations circulate widely in the market, the money supply helps reduce in the short run. However, the money supply will pick up as the new notes circulate in the market, and the mismatch gets corrected.
- It decreases consumption, investments, and employment.
- It also leads to welfare losses for society’s marginalized sections, which depend on the daily wage and can impact the gig economy.
Advantages and Disadvantages
|
Advantages |
Disadvantages |
| Demonetization helps the government track the large sums of black money that tax evaders hide. | Demonetization targets black money. It does not affect many people who maintain cash as their black money and circulate or use it in other asset classes like real estate, gold, etc. |
| Demonetization helps to stall funding terrorism and gambling, inflating the price of substantial asset classes like real estate, gold, and other social evils. | It creates chaos and frenzy among the general public initially. Banks and ATMs could expect long queues while small businesses suffered temporary financial losses. |
| It helps people disclose their income by depositing money in their bank accounts. The government gets a good amount of tax revenue, which they can invest in infrastructure, properties, and development. | The government bears the cost of destroying old currency units and printing new ones. |
Final Thoughts
Demonetization has both advantages and disadvantages. It impacts consumer behavior, and an imbalance of demand and supply within the economy triggers unemployment, squeezes consumption and investment, and creates troubles for gig workers. However, it alone cannot fight the parallel economy and eliminate black money. The government requires several other measures to change the economy for good.
Frequently Asked Questions (FAQs)
Q1. What is Demonetization?
Answer: Demonetization is when a country replaces its current currency units with new ones. It is to avoid or curb illegal activities like black money regulations, terror financing, or control inflation or hyperinflation. India and the USSR practiced demonetization in the past.
Q2. What are the three benefits of Demonetization?
Answer: A significant advantage is that it helps the government track black money. Tax evaders hide large sums of black money they cannot exchange in banks. It also curbs criminal activities and illegal mining tenders and helps the government trace the proportion of currencies at different geographical locations.
Q3. What are the types of Demonetization?
Answer: There are two types of demonetization: Total and partial. The government replaces the current currency units with a new range. In partial, the government changes only some of the existing currency units, and the rest remain in circulation.
Q4. Is Demonetization good for the economy?
Answer: In the short run, Demonetization creates troubles for gig workers and affects consumer consumption. However, in the long run, the process helps in curbing the black money, illegal proportion of money-holders, and the introduction of a cashless economy in the country.
Q5. What are the disadvantages of Demonetization?
Answer: Gig workers are the most affected by the process of demonetization. They are the daily-wage workers, and the availability of liquid cash makes their livelihoods. However, the absence of sudden money can trouble them a lot.
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