India: Demonetisation and the Cash Shortage

Cash shortage, though unusual, is not unknown across countries.  First, countries in the midst of hyperinflation, for example, Austria in 1922 and Germany in 1923, have suffered such shortages.  With galloping prices, there is demand for more and more cash and supply can fall short of demand. Printing extra zeros on currency notes though is not such an insurmountable problem, and the cash shortage could be contained fairly soon. 

by Ashok K. Lahiri


( January 16, 2017, New Delhi, Sri Lanka Guardian) The decision of the Government and the Reserve Bank of India (RBI) to withdraw the legal tender status of the pre-existing Rs. 500 and Rs. 1,000 currency notes beyond November 8, 2016 and the resulting cash shortage have been matters of intense debate, e.g. Rajakumar and Shetty (2016) and Banerjee (2016).[i] The measure, according to the Government, was motivated by the twin objectives of curbing the menace of fake Indian currency notes and for eliminating black money.

The Government decision, according to its own declaration in its Press Release on November 8, 2016, was for “.. curbing financing of terrorism through the proceeds of Fake Indian Currency Notes (FICN) and use of such funds for subversive activities such as espionage, smuggling of arms, drugs and other contrabands into India, and for eliminating Black Money which casts a long shadow of parallel economy on our real economy…”[ii]

Interestingly, even during the two previous episodes of demonetisation of high value notes over Rs. 100 in India, on January 12, 1946 and on January 16, 1978, the express objective of the exercise was containing black marketing or black money.  The official announcement in 1946 stated “The working capital of black market operations is believed to be held in large measure in the form of high denomination notes and the Government are aware of the persistent public demand for effective action against these enemies of public welfare.”[iii]  . In 1978, the High Denomination Bank Notes (Demonetisation) Act, 1978, which followed the Ordnance by the same name on January 16, 1978 demonetising Rs. 1,000, Rs. 5,000 and Rs. 10,000 notes, also stated that the action was needed because such high denomination bank notes facilitate “…the illicit transfer of money for financing transactions which are harmful to the national economy or which are for illegal purposes.”[iv]

Raising questions about the ‘morality’ of the issue, Nobel Laureate Amartya Sen has said “Telling the public suddenly that the promissory notes you have, do not promise anything with certainty, is a more complex manifestation of authoritarianism, allegedly justified – or so the government claims – because some of these notes, held by some crooked people, involve black money. At one stroke the move declares all Indians – indeed all holders of Indian currency – as possibly crooks, unless they can establish they are not.”[v] Mehta (2016) has described it as institutionalisation of a new kind of politics, “… a vast morality play whose three central elements are personification, puritanism and punitive imagination.”

The Supreme Court has started to hear all the petitions regarding demonetisation together on December 2, 2016.[vi]  It is interesting to note though that the apex Court, on November 24, 2009, had observed “Any bonafide measures taken in public interest, and to provide public safety or to prevent circulation of black money, cannot be objected as interference with the personal liberty or freedom of a citizen.” But, the legality and morality of the demonetisation is beyond the scope of this paper, [vii]  This paper also does not deal with how big the scale of the fake currency problem is or how demonetisation will solve it or curb the financing of terrorism and other subversive activities. The aim of this paper is to analyse three questions.  First, when is the cash shortage likely to disappear?  Second, what is likely to be the impact of the cash shortage on growth in the economy?  And third, the likely impact of the demonetisation on ‘black money.’

The plan of the paper is as follows.  Section II describes the recent demonetisation and the resulting cash shortage.  Section III deals with when this shortage is likely to disappear.  Section IV analyses the likely impact of the cash shortage on the performance of the economy.  Section V discusses the bearing that demonetisation is likely to have on ‘black money.’ Section VI concludes.

Demonetisation of November 8, 2016 and the Cash Shortage


After November 9, which was declared to be a bank holiday, the old demonetised Rs. 500 and Rs. 1,000 notes could be deposited, with proper identification, in bank or post office accounts, without any limit, until December 30, 2016.  These could also be exchanged for new Rs. 500 or 2,000 notes, or old Rs. 5, 10, 20, 50 and 100 notes, but initially only up to Rs. 4,000.[viii]  This limit was increased to Rs. 4,500 from November 14, before such direct exchange was completely stopped from November 25, 2016.[ix]

Furthermore, there was a warning that of all cash deposited during the November 10 to December 30, 2016, above a threshold of Rs 2.5 lakh in an account would be matched with income tax returns filed.[x] On November 28, 2016, the Government introduced the Taxation Laws (Second Amendment) Bill, 2016 in the Lok Sabha.[xi]  When the cash deposited in a bank or post office account cannot be accounted for in the tax returns of the assessee, the tax on it was proposed to be augmented from a flat rate of 30 per cent plus surcharge plus cess to 60 per cent plus surcharge of 25 per cent of tax, i.e. 75 per cent, together with a penalty provision of 10 per cent of the tax plus surcharge, i.e. a further 7.5 per cent. It also included a scheme called ‘Taxation and Investment Regime for Pradhan Mantri Garib Kalyan Yojana, 2016’ (PMGKY) providing an opportunity to pay taxes with heavy penalty on black money deposited, and come clean. Under the new scheme, the effective tax rate on the declared income would be 50 per cent, with 25 per cent of the disclosed sum invested for four years in the interest free government deposit scheme.

There are many instances across the world when a country has decided to discontinue with some specific high value currency notes.  For example, Canada stopped issuing the Canadian $1,000 notes from September 2010 on the advice of the Solicitor General and the Royal Canadian Mounted Police (RCMP), as it was often used for money laundering and organized crime.[xii] Given “risks associated with large value cash transactions and high-value notes”, Singapore, in July 2014, decided to stop printing the S$10,000 note, one of the world’s most valuable bank notes.[xiii] European Central Bank (ECB), in May 2016, announced that it would stop printing the Eur 500 notes from 2018.[xiv] In these countries, the banks were advised to return the relevant high denomination notes to the central bank for destruction, but these high value notes continued to be legal tender.

There are two major differences between the stoppage of printing of high value notes in these OECD countries and the recent Indian demonetisation.  In India, the Rs. 500 and Rs. 1,000 notes can be returned to the RBI with proper documentation even after December 30, 2016, but unlike in the countries mentioned above, these old high value notes are no longer legal tenders beyond November 8, 2016. An additional difference is that while the old Rs. 500 and Rs. 1,000 have been demonetised, not only will the new Rs. 500 continue, but a note of even higher denomination than Rs. 1,000, namely Rs. 2,000,  has been introduced.  If there are risks associated with Rs. 500 and Rs. 1,000 notes, such risks will be even more with Rs. 2,000 notes.

Cash shortage

Normally, current and savings accounts at banks are fully and freely convertible into cash at par.  A cash shortage arises with suspension of this convertibility. With cash shortage, a firm or an individual may have money in the bank, but cannot withdraw as much of it as desired in cash.

Simultaneously with the demonetisation, restrictions were imposed on over the counter cash withdrawal from accounts at banks and post offices of Rs.10,000 subject to an overall limit of Rs. 20,000 in a week for the first fortnight.  The limit was increased on November 25 to Rs. 24,000 per week without any daily sub-limit.  Daily withdrawals from Automatic Teller Machines (ATM) were restricted to Rs. 2,000 per account until November 13, 2016, and increased to Rs. 2,500 thereafter. Shortage of small coins has been reported to be a problem for some time.[xv] But, a generalised cash shortage is a new experience in India. Even for the withdrawal of the limited sums, there were long queues and endless waits outside banks.  Often, in the initial days, success required multiple attempts over more than a day.

What was demonetised on November 8, 2016 was more than 85 per cent of the currency in circulation.  On March 31, 2016, out of Rs. 16.6 trillion cash in circulation, the value of Rs. 500 and Rs. 1,000 notes in circulation was Rs. 14.2 trillion.  On November 8, 2016, this value of Rs. 500 and Rs. 1,000 notes in circulation may have grown to an estimated Rs.15.4 trillion (Table 1). With so much of the currency demonetised, a cash shortage is not surprising.

Cash shortage, though unusual, is not unknown across countries.  First, countries in the midst of hyperinflation, for example, Austria in 1922 and Germany in 1923, have suffered such shortages.  With galloping prices, there is demand for more and more cash and supply can fall short of demand. Printing extra zeros on currency notes though is not such an insurmountable problem, and the cash shortage could be contained fairly soon.

Second, it has arisen when a country, e.g. Panama, used another country’s currency, e.g. the US dollar, as legal tender, and is cut off from the supply of such currency for geo-strategic reasons.[xvi]  In mid-1987, under Manuel Noriega, the country, famous for the Panama Canal, came into conflict with the US. In March 1988, US froze $50 million of its deposits in New York banks. Panama had to suspend check clearing functions and also impose restrictions on cash withdrawals from banks, resulting in a cash shortage.

Third, it can arise in a country which gets its currency printed abroad and is faced with a severe foreign currency crisis.  In mid-1992, Albania, in the midst of a severe foreign exchange crisis, was unable to get its currency, the Lek (named after Alexander the Great), printed abroad, and faced a cash shortage.

Fourth, cash shortage is quite common during the disintegration of large states or empires.  It occurred in the constituent parts of the Austro-Hungarian Empire in 1918-19.  During the break-up of Yugoslavia, in the spring of 1991, the National Bank of Yugoslavia in Belgrade stopped the delivery of cash Yugoslav dinars to Croatia and Slovenia plunging these two into a situation of cash shortage until the introduction of their own currencies. The most well-known recent case of cash-shortage is from the republics of the former Soviet Union (FSU) when it broke up at end-1991, see for example Hardy and Lahiri (1994).[xvii]

The demonetisation in India on November 8, 2016 and the resulting cash shortage thereafter are very different from all the cases discussed above.  There was no antecedent extraordinary circumstance such as hyperinflation or dependence on another country’s currency.

How long will the Cash Shortage persist?

Initial popular sentiments appeared to endorse the government’s announced crusade against corruption and black money with demonetisation.  Problems have arisen from the resulting cash shortage, which has disrupted people’s lives and economic activity.  A temporary cash shortage may have been ignored, but the persistence of the problem has raised questions about how long this shortage is likely to persist.

The government has claimed that the shortage will disappear by the end of the current calendar year.  Chaudhuri (2016) has said that it will take much longer, perhaps as long as up to May, 2017. So, how long will it take? The answer depends on how much of the demonetised Rs. 500 and Rs. 1,000 currency notes will have to be substituted with valid notes of equivalent value and how soon they can be printed and distributed.

How much of the demonetised notes will have to be substituted with valid notes in turn depends on two factors. First, how much was presented for over-the-counter conversion between November 9 and November 24, and how much will be deposited in bank and post office accounts.  On January 12, 1946, when currency notes of the value of Rs. 500, Rs. 1,000 and Rs. 10,000 were demonetised by an ordinance, in total, such notes in circulation were Rs. 143.97 crore. By the end of 1947, Rs. 134.9 crore, or 93.7 per cent were exchanged.[xviii] On January 16, 1978, when currency notes of denominations Rs. 1,000, Rs. 5,000 and Rs. 10,000 were demonetised, the total amount in circulation was Rs. 145.42 crore.[xix]  Of this, 89.0 per cent or Rs.129.4 crore came back for exchange.[xx] It is reasonable to assume that, for fear of detection, ‘black money’ circulating in the form of currency will have a tendency not to come back for exchange. Given the decrease in the proportion surrendered for conversion between 1946 and 1978, and the increased efficiency of tax administration and banking industry in monitoring such conversion, 85 per cent can be taken as a conservative estimate of such conversion in the current round.  An optimistic estimate can be 80 per cent.[xxi]

Second, even when the demonetised notes are deposited in bank or post office accounts, these may be kept as deposits, without necessarily being withdrawn in the form of currency.  It is likely that the current cash shortage may have given a stimulus to the banking habits and cashless transactions among the population.  Compelled by the cash shortage, many may have realised the potential of the debit and credit cards, on-line transfers and other digital payments facility such as mobile payments.  Furthermore, the preference for cash in transactions is partly motivated by the objective of avoiding detection for tax purposes.  If the government can indeed improve detection of tax evasion and enforcement of tax compliance, the transaction demand for cash relative to that for deposit money may go down.

The payments system in India indeed is in ‘the cusp of a revolution.’ The Indian payments revolution of the future may be as fast as the revolution in mobile telephony in the recent past.  But India still is a cash-intensive country. 

It is important to note, however, that the demand for currency relative to deposit money also depends on the confidence that people have in the banking system and its ability to convert deposits into cash at sight. During the Great Depression in the United States, that began in November 1930 and persisted for 2½ years, nominal gross national product fell by 38 per cent, deposits fell by 33 per cent, and currency with the public rose by 55 per cent, resulting in a rise in the currency-deposit (CD) ratio, see Boughton and Wicker (1979). Will the recent demonetisation exercise, by shaking up public confidence in the banks’ unrestricted ability to convert deposits into cash, also work the same way enhancing the CD ratio? Given that people seem to have accepted the demonetisation as a one-off exercise for tackling black money, this stimulation of the demand for currency relative to deposits is likely to be negligible.

As Figure 1 demonstrates, the CD ratio in India has been on a declining trend. But this ratio is still almost 50 per cent higher than that in OECD countries, and is likely to go down further.  The recent demonetisation may give a fillip to the process, at least temporarily. What happened in Europe during the Euro cash changeover in 2002, namely a de-hoarding of cash in the run up o the changeover followed by a re-hoarding, is likely to happen in India as well following the recent demonetisation, namely a sharp reduction in the CD ratio followed by slow recovery.[xxii]  A reduction in interest rates because of excess cash in banks is likely to reduce the opportunity cost of holding currency relative to deposits in banks, and help the equilibration of the CD ratio.

Source: Table 44. Components of Money Stock, Reserve Bank of India — Handbook of Statistics of the Indian Economy.

Of the Rs. 16.6 trillion currency in circulation on March 31, 2016, as much as Rs. 7.9 trillion and Rs. 6.3 trillion were in Rs. 500 and Rs. 1,000, respectively,  a total of 85.2 per cent.  A part of this Rs. 14.2 trillion in Rs. 500 and Rs. 1,000 notes were held by banks.  Given that total currency held by banks at end-March 2016 was Rs. 0.7 trillion or 3.98 per cent of total currency in circulation, applying the simplistic assumption of the same proportion being valid for Rs. 500 and Rs. 1,000 notes held by banks, the value of Rs. 500 and Rs. 1,000 notes held by the public are obtained as Rs. 7.5 trillion and Rs. 6.1 trillion, respectively.

It is important to note that the nominal value of cash holding that was demonetised on November 8 was more than the corresponding stock on March 31, 2016.  Between March 31, 2015 and March 31, 2016, Rs. 500 and Rs. 1,000 notes in circulation grew by 19.7 per cent and 12.7 per cent, respectively.  So, on November 8, 2016, it is reasonable to assume that Rs. 500 and Rs. 1,000 notes held by the public could have been around Rs.8.3 trillion and Rs. 6.5 trillion, respectively, that is about 10.0 per cent and 6.5 per cent higher than the corresponding figures on March 31, 2016.

Though a part of the currency with banks held in the form of Rs. 500 and Rs. 1,000 notes will also have to be substituted by other notes, there may not be a great urgency for such substitution as long as the exchange of such notes held by the public goes on smoothly and total deposits are not declining. Assumption that the same proportion of Rs. 500 and Rs. 1,000 notes in circulation was with banks, and growth was 10.0 per cent and 6.5 per cent in such holdings from March 31 yields 16.6 billion of Rs. 500 notes and 6.5 billion Rs. 1,000 notes held by the public on November 8, 2016 (Table 1).

If a uniform 15 per cent of such notes do not come back for circulation because of the anti-black money measures, then only 14.1 billion Rs. 500 notes and 5.5 billion of Rs. 1,000 notes will be deposited into accounts or presented for conversion into other notes.  A more aggressive assumption of 20 per cent of such notes not coming back yields 13.3 billion Rs. 500 notes and 5.2 billion of Rs. 1,000 notes for conversion into either legal tender cash or deposits (Table 1).

Table 1.  Post Demonetisation Conversion of Rs. 500 and Rs. 1,000 notes into Currency
(Number, in billion)
Rs. 500 Rs. 1,000 Rs. 2,000
On November 8, 2016
(i) In circulation 17.28 6.74
(ii) With the public (96% of circulation) 16.59 6.47
(iii) Conservative — 85% deposited or converted
a. Converted or deposited in accounts 14.10 5.50
b. With the public in currency 12.98                – 2.53
(iv) Aggressive — 80% deposited or converted
a. Converted  or deposited in accounts 13.27 5.17
b. With the public in currency 12.15                – 2.37

On December 13, 2016, RBI in a press release reported that, between November 10 and December 10, 2016, Rs. 12.4 trillion worth of old Rs. 500 and Rs.1,000 notes were returned to RBI and the currency chests.[xxiii]  How does this figure tally with the assumptions in Table 1 of only 85 per cent or Rs. 12.5 trillion, or even worse, only 80 per cent or Rs. 11.8 trillion, of the old Rs. 500 and Rs. 1,000 notes getting deposited or converted by the public?  There are two reasons why the two may be consistent with each other.  First, the amount reported by the RBI includes deposits or returns by banks, not only the public.  Second, it is not clear as to how much of the cash deposited will turn out to be unaccounted and subject to the provisions of the Taxation Laws (Second Amendment) Bill, 2016 passed by the Lok Sabha on November 29, 2016.  The amount of old Rs. 500 and Rs. 1,000 notes deposited and subject to the amended provisions should also be excluded from the calculation of amount deposited by the public.

How much of these Rs. 500 and Rs. 1,000 notes deposited in accounts will be withdrawn in the form of currency is the next important question.  Between October 28 and November 11, 2016, currency with the public went down from Rs. 17.0 trillion to Rs. 15.3 trillion, while currency with banks rose from Rs. 759 billion to Rs. 2.6 trillion.  The decline in currency with the public was also reflected in a rise in time deposits from Rs. 96.5 trillion to Rs. 97.5 trillion.[xxiv] The currency deposit ratio, as a result, went down from 15.9 per cent on October 28 to 14.1 per cent on November 11. But this decrease in the CD ratio was not because the people wanted less currency, but because they could not withdraw cash even if they wanted to.

While some of the de-hoarding of high denomination notes is likely to be reversed over time, the CD ratio is unlikely to go back to its October 28 value.  If the CD ratio does not go back up beyond 15.0 per cent, which is likely for the reasons already adduced, and the reduction in currency with the public is entirely in terms of Rs. 500 and higher denomination notes, the holding of such notes may go down by a further total of Rs. 1 trillion which is the rise in the time deposits with banks between October 28 and November 11. This is over and above the amount that does not come back as deposit at banks or for conversion into valid notes at all under the two scenarios.

Distributing this Rs. 1 trillion reduction in the same ratio as Rs. 500 and higher denomination notes circulating on October 28, i.e. 56.2 per cent and 43.1 per cent, the number of Rs. 500 notes that will be demanded in the form of cash is obtained as 12.98 billion under the conservative scenario and 12.15 billion under the aggressive scenario.  Since what is being supplied in terms of currency notes in denomination higher than Rs. 500 is Rs. 2,000, under the simplifying and somewhat heroic assumption that the public will willingly accept the substitution of Rs. 1,000 old notes by the new Rs. 2000 notes, the corresponding numbers for Rs. 2,000 notes are 2.53 billion and 2.37 billion.

The payments system in India indeed is in ‘the cusp of a revolution.’[xxv] The Indian payments revolution of the future may be as fast as the revolution in mobile telephony in the recent past.  But India still is a cash-intensive country.  Though it may be moving towards being less cash-intensive, the on-going payments revolution by itself is unlikely to solve the post-demonetisation cash shortage in the immediate future.

Table 2. Indent and Supply of Banknotes by BRBNMPL and SPMCIL
(Million pieces)
Denomination (₹) 2013-14 2014-15 2015-16 2016-17
Indent Supply Indent Supply Indent Supply Indent
1 2 3 4 5 6 7 8
5             –             –             –             –             –             –             –
10      12,164        9,467        6,000        9,417        4,000        5,857        3,000
20        1,203           935        4,000        1,086        5,000        3,252        6,000
50           994        1,174        2,100        1,615        2,050        1,908        2,125
100        5,187        5,131        5,200        5,464        5,350        4,910        5,500
500        4,839        3,393        5,400        5,018        5,600        4,291        5,725
1000           975           818        1,500        1,052        1,900           977        2,200
Total      25,362      20,918      24,200      23,652      23,900      21,195      24,550
Source: RBI Annual Report, 2016, p. 90.

Bank notes are printed at four note presses: at Currency Note Press, Nashik and Bank Note Press, Dewas, both owned by Security Printing & Minting Corporation of India Ltd. (SPMCIL); and at Mysuru and Salboni, owned by Bahratiya

Reserve Bank Note Mudran Limited (BRBNML), a wholly-owned subsidiary of the RBI. SPMCIL is wholly owned by Government of India.  The printing capacities of these four units are not readily available in the public domain.  But, the RBI’s Annual Report 2016 (Table VIII.4, p. 90) provides the indents for and supply of currency notes by the four units during the last three years reproduced below as Table 2.

Table 2 does not paint a rosy prospect for the rapid amelioration of the cash shortage. The total number of pieces of currency supplied was 20.9 billion in 2013-14, 23.6 billion in 2014-15 and 21.2 billion in 2015-16. Supply fell short of indent by 17.5 per cent, 2.3 per cent and 11.3 per cent in these three years in sequence.  The maximum Rs. 500 and Rs. 1,000 notes supplied in the last three years were in 2014-15 — at 5.0 billion and 1.0 billion, respectively.

The required number of Rs. 500 notes in the two scenarios to wipe out the cash shortage is 12-13 billion pieces, which is more than twice the maximum produced in the whole year of 2014-15.  Similarly, even if the old Rs. 1,000 notes are replaced by Rs. 2,000 notes, the corresponding requirement of Rs. 2,000 notes at 2.4-2.5 billion pieces exceeds the maximum annual production of Rs. 1,000 notes achieved in 2014-15 by a factor of more than two.

The maximum number of pieces of currency notes – irrespective of denominations – produced by all the four currency presses together was 23.7 billion. The total requirement of Rs. 500 and Rs. 2,000 notes for removing the cash shortage is between 14.5 and 15, 5 billion, or .between 32 and 34 weeks of the rate of production achieved in 2014-15.  Thus even if the currency presses were to produce only Rs. 500 and Rs. 2000 notes with the same level of efficiency as in 2014-15, the shortage would disappear only by mid-June or the first week of July 2017.

A little more than a fortnight before the demonetisation, on the new Rs. 2,000 note, the Hindu Business Line (2016) reported that the RBI “… has very nearly completed preparations for introducing this new high-value currency …. The notes have already been printed, and their despatch from the currency printing press in Mysuru has commenced.” While no figures are available about how many Rs. 2,000 notes were printed before November 8, it is assumed that such production was negligible at around a couple of million at most.

Meeting the demand for Rs. 500 and Rs. 2,000 denomination notes in 50 days would require a daily production of 290-310 million pieces, which is 106-109 billion pieces per year.   Meeting the 50-day deadline requires the currency presses to ramp up their production at least four-fold.  Even when a currency press starts operating three shifts instead of two, production is unlikely to increase by more than 50 per cent.  A four-fold enhancement of output of the four currency printing presses within a short time may be a mission impossible.

On December 13, 2016, RBI, in its press release, also reported that, between November 10 and December 10, 2016, the banks issued notes valued at Rs.4.61 trillion to the public over their counters and through their ATMs. Of the 21.8 billion pieces of notes supplied, 20.1 billion were in denominations of Rs. 10, 20, 50 and 100s, and 1.7 billion were in higher denominations of Rs. 2,000 and Rs. 500. These figures reported by the RBI seem to strengthen the conclusions about the shortage continuing for some time.

A quick way to relieve the shortage would be to consider the strategy that the government under Prime Minister Atal Bihari Vajpayee adopted in 1998.  Among other things, it decided to import 3,600 million pieces of printed notes adding up to a face value of Rs 1 trillion to rapidly wipe out the cash shortage.[xxvi]

Apart from printing the notes of various denominations, there is also the challenge of reaching the appropriate amount of currency to the various places all across the large country. The act of coordinating such transportation to and storage at the 29 issue offices of The RBI and 4,442 currency chests needs to be handled with appropriate delicacy.[xxvii]

How the Cash Shortage will affect Inflation and Growth

Currency and deposit money or credit cards are not perfect substitutes as medium of exchange in many transactions.  For example, daily wage of an unskilled or semi-skilled worker, retail purchases from a street vendor, or even vegetables in the mandis or wholesale markets in many places cannot be paid for in anything but cash.  The cash shortage has affected trading and production in many segments of the informal economy. An additional cost is the man-days lost queuing up at banks for conversion or deposit of old currency.

The cash shortage may have already affected the prices of perishable goods and services.  Prices of vegetables in wholesale markets, according to newspaper reports, have fallen significantly.[xxviii]  Vegetable prices go down around this time of the year because of seasonality, but perhaps cash shortage has been an additional factor affecting such price decrease. Overall inflation may come down because people have less of one common medium of exchange, namely cash, to transact, but this decline in inflation will be tempered by how much output also goes down because of the lack of cash as working capital.

Table 3. GDP and Narrow Money — Three Scenarios with Demonetisation
(Growth in per cent)
  GDP at current prices M1 (average) GDP/M1 (average)
  in Rs. billion Growth year-on-year in Rs. billion Growth year-on-year
Q1       31,746 8.85       23,576 10.34 1.35
Q2       32,486 6.41       23,425 10.26 1.39
Q3       34,760 9.07       24,102 11.56 1.44
Q4       36,768 10.36       25,200 12.62 1.46
Q1       35,055 10.42       26,784 13.61 1.31
Q2       36,420 12.14       27,131 15.82 1.34
Scenario I (cash shortage more than made up by year-end)
Q3       39,126 12.56       26,983 11.96 1.45
Q4       40,924 11.30       28,030 11.23 1.46
Scenario II (cash shortage just made up by year-end)
Q3       38,637 11.15       26,831 11.33 1.44
Q4       39,489 7.40       27,234 8.07 1.45
Scenario III (cash shortage is reduced but not made up by year end)
Q3       38,236 10.00       26,739 10.94 1.43
  Q4       38,247 4.02       26,746 6.13 1.43
Source: Weekly Statistical Table No. 6, RBI and Press Releases of Central Statistical Organisation, Ministry of Statistics and Program Implementation, Government of India dated May 31, 2016 and November 30, 2016

Money is the lubricant that keeps the wheel of economic activity moving. A standard, albeit simplistic, approach to analysing the impact of the cash shortage is to fall back on Cambridge equation of the quantity theory of money.[xxix] Three scenarios are considered (Table 3).

In Scenario I, both currency with the public and demand deposits at end-March 2017 are 10 per cent higher than the corresponding figures a year ago.  Effectively this implies that under Scenario I, at the end of 2016-17, currency with the public gets more than restored to what it was before the demonetisation.  Although the year-on-year (y-o-y) growth of both currency with the public and demand deposits is the same 10 per cent, post-demonetisation, growth of currency is over Rs. 2.3 trillion compared to only Rs. 84 billion growth in demand deposits.

Under Scenario II, y-o-y growth of currency and demand deposits is 6.5 per cent and 5 per cent, respectively.  While the y-o-y growth in demand deposits is 5 per cent, such deposits decline by Rs. 419 billion post-demonetisation signifying a shift from demand deposits to currency.  At the end of 2016-17, while currency with the public exceeds the pre-demonetisation level by Rs. 556 billion in Scenario I, such currency is just about restored to the pre-demonetisation level under Scenario II.

Scenario III considers the case, where the authorities fail to make up for the cash shortage by end-March 2017 and currency with the public, with y-o-y growth of only 4 per cent, falls short of the pre-demonetisation level by Rs. 402 billion.   Demand deposits grow, y-o-y, only by 4 per cent, and, even more than under Scenario II, is Rs. 670 billion lower than what it was on November 11, 2016 after the demonetisation.

In all the three scenarios, the growth of M1 from November 11, 2016 – the first reporting Friday for banks after demonetisation – to March 31, 2017 has been assumed to follow a straight-line path of equal absolute change every fortnight.  Gross domestic product (GDP) at current prices for the third and fourth quarters of 2016-17 is projected by assuming the income velocity values.

Needless to say, Table 3 is for illustrative purposes.  It shows that the impact of the cash crunch, if it persists, is going to most severe in the fourth quarter.  Almost half the third quarter had passed before the cash crunch set in.  If the cash shortage persists, nominal growth could be as low as 4-7 per cent in the fourth quarter depending on how severe the shortage is.

GDP for 2016-17 is obtained by adding up the quarterly GDP figures.  Growth declines from 11.6 per cent under Scenario I to 10.2 per cent under Scenario II and 9.0 per cent under Scenario III. Under the heroic assumption that nominal growth will be coming equally from real growth and inflation, the growth impact of the cash shortage is 0.7-1.3 per cent depending on how much of the cash shortage continues to persist and for how long. Of course, over the long run, how the economy will be affected will depend on how far the demonetisation is followed up by other suitable anti-black money measures and how effectively the shadow economy is controlled.

Demonetisation and the Black Economy

Demonetisation as an antidote for black money has been a somewhat popular demand for some time. For example, in 1972, when M. G. Ramachandran split up from Dravida Munnetra Kazhagam (DMK), the socio-economic principles and objectives expounded by the new party All India Anna DMK (AIADMK) was collectively called Annaism, named after the late C. N. Anna Durai.

Annaism included demonetisation of hundred-rupee notes to eliminate black money (Sastry 1974: 529).

The demand for withdrawing or moving towards elimination of high denomination notes is not restricted to India alone.  There is a view that the Federal Reserve in the United States, the Swiss National Bank and the Bank of England should also stop issuing $100, the CHF1,000 note and the £50 notes as these are the favourites by terrorists, drug lords and tax evaders.[xxx]

Admittedly, much of the underground economy is cash-based. Illegal activities in particular, such as accepting bribes, including to political parties as ‘donations’, drug trafficking, prostitution, bootlegging and gambling, tend to be on a cash basis. Unreported income from lawful activities, such as legal and medical counselling, from tips, from work by household and farm help, from independent contracting, also tend to be in cash.[xxxi]  The black component of currency is that part of currency that has just mediated a black transaction and is still with the perpetrator.

The universal acceptability of cash, the convenience in storing, moving and hiding it, and the associated anonymity are the factors that lead to its use for such purposes. Even within currency notes, high denomination notes are the preferred medium of transaction. While Rs. 1 crore in Rs. 1,000 notes weigh around 12 kg, the same in Rs. 500 notes weigh about twice as much, and in Rs. 100 notes several times more.  However, the recent demonetisation in India is not a scrapping of high denomination notes.  In fact, not only will new notes of Rs. 500 denomination be there, even a Rs. 2,000 denomination note has been introduced after the demonetisation.

It is important to note that the term ‘black money’ in popular parlance is used to refer to three distinct categories – black wealth, black income and black currency – the term ‘black’ connoting its ‘illegal’ or unaccounted nature. Clearly, black wealth is several times more than black income — it is what has been accumulated from black income over several years. And black income is several times more than black currency. Black income can be earned even without the use of currency, for example with gold or diamonds.  Is demonetisation going to eliminate all three from India?  The answer is a categorical ‘NO.’  It will, on its own, at best, confiscate a part of the high denomination currency that has been used for generating black income and are still with the perpetrator.  So, with proper enforcement, what can demonetisation achieve?

First, it is important to note that given the surprise in the sudden demonetisation, the Rs. 500 and Rs. 1,000 notes that were received by people in unaccounted or illegal transactions and were waiting to be laundered will face some difficulties in getting converted into cash that is legal tender or into deposits.  This will be particularly true for sums above Rs. 2.5 lakh.  A part of it may get laundered into deposits in small lots of other people, and received back in the form of valid cash, after payment for the conversion services rendered.[xxxii] But, this technology for conversion will not be easily available for large sums of say Rs. 1 crore and above.

A large shadow economy is estimated by some at over a fifth of gross domestic product. This, along with the change in societal norms towards a more accepting attitude, bordering cynicism, towards black money, is troubling.  The big painful jolt of demonetisation creates the right psychological milieu for the war against black money to start, some claim.

The success of demonetisation in stopping such conversion of ‘black’ cash into ‘white’ cash may be evaluated by how much of Rs. 500 and Rs. 1,000 do not get deposited or converted by December 30th.  Of course, it will depend on how effectively the demonetisation and tax laws are simultaneously enforced. As already discussed, given that the proportions of demonetised currency in circulation that did not get exchanged during the demonetisation in 1946 and 1978 were about 6 per cent and 11 per cent, respectively, with the strides made in digitisation of tax returns and bank records together with PAN, AADHAR and know your customer (KYC) regulations, the current demonetisation may be judged to be successful if the proportion of the demonetised notes not exchanged into deposits or cash is at least Rs. 2 trillion. Second, governments have been long on the rhetoric about eradicating black money and short on detecting the wrong doers.  There have been at least a dozen voluntary disclosure schemes, e.g. in 1951, 3 in 1965, 1975, 1981, 1985, 1991, 1993 and 1997, but they have not been successful in fighting the generation of black money again.[xxxiii]

India continues to suffer from the problem of a large shadow economy. The size of the shadow economy is estimated in 2007 by Schneider et al at 22.2 per cent of GDP, compared to China’s 12.7 per cent and Japan’s 11.7 per cent.[xxxiv]   Many people believe that societal norms have become more accepting towards black money. Cynicism has reached very high levels.  There is a presumption that most politicians, bureaucrats, policemen, doctors, lawyers and even some members of the judiciary have compromised on following the highest standard of probity. This is dangerous. People imitate each other in certain ways to establish cooperative relationships and this is at the root of the evolution of social norms.[xxxv] Corruption, when not rejected by social norms, can become endemic in a society.

A large shadow economy is estimated by some at over a fifth of gross domestic product. This, along with the change in societal norms towards a more accepting attitude, bordering cynicism, towards black money, is troubling.  The big painful jolt of demonetisation creates the right psychological milieu for the war against black money to start, some claim. Are government steps, such as the Income Declaration Scheme (IDS) in the Budget for 2016-17, monitoring black money stashed abroad with the Tax Exchange Information Agreements with several countries, the August 2016 amendment of the Benami Transactions (Prohibition) Act of 1988, and the Taxation Laws (Second Amendment) Bill in November 2016, parts of a concerted plan? Will it be any different from what followed in 1946 and 1978? Only time will tell.


Demonetisation of Rs. 500 and Rs. 1,000 notes on November 8, 2016 has become a matter of intense debate.  Production of high value notes have been discontinued by many countries because these are often used for money laundering and organized crime. The Indian demonetisation is considerably different from such scrapping of high value notes.  Such scrapping typically involves stopping the production of high value notes and asking the banks to return such notes for destruction by the central bank.  But the high value notes continue to be legal tender.  In India, the old Rs. 500 and Rs. 1,000 notes have ceased to be legal tenders, and not only does the production of new Rs. 500 notes continue, but a new Rs. 2,000 note has been introduced as well.

The post-demonetisation situation has been complicated by a cash shortage disrupting people’s lives and economic activity.  Sentiments of a large section of the people appear to endorse the government’s announced crusade against corruption and black money with demonetisation.  But the persistence of cash shortage may not only erode such support but also affect the economy, particularly in the fourth quarter of 2016-17. It is imperative that the cash shortage be rapidly removed by suitable action, if necessary through import of currency printed abroad.

High value notes have been demonetised three times so far in India – in 1946, 1978 and 2016.  On all the three occasions, the objective was containing black money.  The outcome after the two previous exercises in 1946 and 1978 has not been very inspiring.   This time, there appears to be a concerted plan of action, including changes in tax laws and legal treatment of benami

transactions. Only time will tell whether 2016 is different from 1946 and 1978, but an initial feedback will be available from how much of the old Rs. 500 and Rs. 1,000 notes in circulation does not get deposited into accounts or get exchanged into valid notes, or ‘vanishes’ by end-December, 2016.  In 1946 and 1978, this vanishing proportion was 6.3 per cent and 11.0 per cent, respectively.  Fifteen per cent or more, that is at least Rs. 2 trillion worth of old Rs. 500 and Rs. 1,000 notes, not coming back for exchange will give an early indication that this time it may be different from the past.  But even after clearing the muck of currency that was mediating illegal or unaccounted transactions in the recent past, what will remain is the larger job of preventing its accumulation in the future.


Banerjee, Sumanta (2016): “Narendra Modi, Bob Dylan and Demonetisation,” Economic & Political Weekly, Vol. LI, no 48, November 26, 2016, pp. 21-22.

Boughton, James M. and Elmus R. Wicker (1979): “The Behavior of the Currency-Deposit Ratio during the Great Depression,” Jounal of Money, Credit and Banking, Vol. 11, No. 4 (Nov., 1979), pp. 405-418.

Chaudhuri, Saumitra (2016): “Even as world changes under Trump, India’s currency shortages will stay for months,” Economic Times Blogs, November 15, 2016.

ECB (European Central Bank) (2003): “The demand for currency in the euro area and the impact of the euro cash changeover”, Monthly Bulletin, ECB, January 2003. Pp. 39-51.

Hardy, Daniel and Ashok K. Lahiri (1994): “Cash Shortage in the Former Soviet Union,” International Monetary Fund, WP/94/67, June 1994. Also published in Journal of Comparative Economics, Vol. 22, 1996, pp. 119-140.

Hindu Business Line (2016): “Coming soon to your wallet: ₹2,000 notes,” October 21, 2016.

Joseph, Nikhil, Ruben Korenke, Benjamin D. Mazzotta, and Bhaskar Chakravorti (2013): “Cash Outlook – India,” Working Paper 13-01, The Institute for Business in the Global Context, The Fletcher School, Tufts University, 2013.

Khan, S. S. (2012): “Tax Amnesties in India,” TII Special, March 12, 2012,

Lahiri, Amartya (2016): “The demonetisation boondoggle,” Business Standard, December 4, 2016.

Mehta, Pratap Bhanu (2016):  “You have been warned,” Indian Express, November 17, 2016

Mirus, Rolf and Roger S. Smith (1981): “Canada’s Irregular Economy,” Canadian Public Policy / Analyse de Politiques, Vol. 7, No. 3 (Summer, 1981), pp. 444-453.

Posner, Eric (2000): “Law and Social Norms,” Harvard University Press, 2000.

Rajakumar, J Dennis and S. L. Shetty (2016): “Demonetisation 1978, the Present and the Aftermath,” Economic & Political Weekly, Vol. LI, no 48, November 26, 2016, pp. 13-17.

Sastry, K Ramaswamy (1974): “A Chronicle of the DMK Split,” Economic & Political Weekly, Vol. IX, no 13, March 30, 1974, pp. 527+529-531.

  • Comments by Subhomoy Bhattacharya about data source are gratefully acknowledged.

[i] There were some exceptions to their use, such as in government hospitals and petrol pumps.


[iii] “Govt. Strike at Black Capitalists: Notes of Rs. 500, Rs. 1,000 and Rs. 10,000 cease to be legal tender,” The Indian Express, January 13, 1946.  Also reproduced in “Demonetisation: Newspaper Headlines From 1946 Tell a Story Similar to 2016,”, November 14, 2016,

[iv] The High Denomination Bank Notes (Demonetisation) Act, 1978, March 30, 1978. In 1978, the government had also expressed its concern about the rising trend in agricultural prices, particularly edible oils and suspected black money going into the hoarding of and speculation on such sensitive commodities.

[v] “Interview: Demonetisation move declares all Indians as possible crooks, unless they can establish otherwise, says Amartya Sen”, Indian Express, November 26, 2016.

[vi] “Demonetisation: Supreme Court defers hearing of petitions against ban to December 2,” Times of India, November 25, 2016,

[vii] Rajendran Chingaravelu vs Mr. R.K. Mishra, Additional Commissioner of Income Tax, Civil Appeal No. 7914 of 2009), NOVEMBER 24, 2009.

[viii] The Government Press Release of November 8, 2016 stated “ (i) Old High Denomination Bank Notes may be deposited by individuals/persons into their bank accounts and/or exchanged in bank branches or Issue Offices of RBI till the close of business hours on 30th December, 2016. (ii) Old High Denomination Bank Notes of aggregate value of Rs.4,000/- only or below held by a perhear all the peson can be exchanged by him/her at any bank branch or Issue Office of Reserve Bank of India for any denomination of bank notes having legal tender character, provided a Requisition Slip as per format to be specified by RBI is presented with proof of identity and along with the Old High Denomination Bank Notes. Similar facilities will also be made available in Post Offices.”

[ix] For the increase in the conversion limit from Rs. 4,000 to Rs.4,500 see Press Relaese of November 13, 2016,  The Press Release of November 8, 2016 had stated that the limit of Rs, 4,000 on the exchange of old notes for other valid ones would be ‘..reviewed after 15 days and appropriate notification issued, as may be necessary.” In a Press Release on November 24, 2016, over the counter exchange of old Rs. 500 and Rs. 1000 notes were banned after midnight of November 24, 2016.

[x] “Deposits above Rs 2.5 lakh to face tax, penalty on mismatch,” The Economic Times, November 10, 2016.

[xi] Government of India, Press Release, November 28, 2016,

[xii] “Bank of Canada kills $1000 bill,” CBC News, September 26, 2010,

[xiii] “Singapore to stop issuing S$10,000 banknote to prevent money laundering,” Reuters, July 2, 2014.

[xiv] “500-Euro Banknote Being Phased Out,” The Wall Street Journal, May 4, 2016.

[xv] With the circulation of small coins almost unchanged at Rs. 7 billion for the past four years, many have the experience of getting a lozenge, or even green chillies in lieu of 50 paise change from the shop keeper. Small traders often complain of having to buy Rs. 100 worth of small change for Rs. 10 premium. “Shortage of small change leads to big problem,” The Hindu, August 20, 2015,

[xvi] Panama has a currency called the Balboa, which is tied to the US dollar at par, but it also allows the US dollar as legal tender.

[xvii] As it is, the FSU had two semi-independent monetary circuits, with households receiving their wages in cash, depositing excess cash in banks and withdrawing cash to spend on goods and services.  Enterprises had very little freedom in cash management.  They needed plan authorisation to operate their bank accounts.  There was no system of cheques. Inter-enterprise payments were by payment orders through the inter-bank settlement system.

[xviii] “History of the Reserve Bank of India (1935-51)”, Vol. I, Reserve Bank of India, Bombay, original 1970, reprinted 2005,, p. 709.

[xix] Finance Minister H. M. Patel, introducing the ‘High Denomination Bank Notes (Denomination) Bill” in Parliament,  March 21, 1978.

[xx] H. M. Patel, July 18, 1978, in Parliament: “The demonetisation of high-denomination notes had the limited objective of stopping the illicit transfer of money for financing transactions, which, apart from resulting in tax evasion, were harmful for a healthy growth of the economy. The measure resulted in the high-denomination banknotes of an approximate value of Rs 16 crore (160 million) not having been tendered for exchange becoming valueless and therefore, would not form part of money supply.”

[xxi] Even in 1978, the largest number of demonetised high currency notes (Rs. 34.76 lakh) were surrendered  by an NGO, Shree Mahavir Health and Relief Society, Surat, and the next five highest surrenders (Rs. 6.5 to Rs. 13.9 lakh) were by small and medium enterprises. Rajya Sabha written answer by

[xxii] ECB (European Central Bank): “The demand for currency in the euro area and the impact of the euro cash changeover”, Monthly Bulletin, ECB, January 2003. Pp. 39-51.


[xxiv] Table 6. Money Stock – Components and Sources, Monthly RBI Bulletin, The difference between the increase in currency holding of banks and decrease in currency with the public was almost equal to the decrease in bank credit to the commercial sector.

[xxv] See Joseph et al (2013).

[xxvi] “In fact: How NDA under Atal Bihari Vajpayee saw high value notes,” Indian Express, November 16, 2016.

[xxvii] The issue offices are at Ahmedabad, Bangalore, Bhopal, Bhubaneshwar, Belapur(Navi Mumbai), Kolkata, Chandigarh, Chennai, Guwahati, Hyderabad, Jaipur, Kanpur, Lucknow, Mumbai (Fort), Nagpur, New Delhi, Patna and Thiruvananthapuram. The currency chests are storehouses where bank notes and rupee coins are stocked on behalf of the RBI by authorised selected branches of banks.

[xxviii] “In Delhi, for example, cauliflower, brinjal (round) and cabbage wholesale prices fell by over 50% each, peas and potatoes by about 40% and tomatoes by 13%.” Times of India, December 2, 2016.

[xxix] This approach was also suggested by Amartya Lahiri (2016).

[xxx] “If you want to move a million dollars in $20 bills, it weighs 110 pounds. It’s actually pretty hard for a single individual to carry surreptitiously 110 pounds. In 500-euro notes, that’s less than 4 pounds.”

[xxxi] It is somewhat less cogent to argue that the medium of exchange for this segment of the irregular economy is strictly currency. For example, a cheque received for irregular activity could be endorsed and used as payment to third parties.

[xxxii] India Today reported how “Poor families, most of whom are farmers are being used to channel the black money. Rich traders are using the bank accounts of these poor families to deposit huge tranche of cash.” “Exclusive: Bank accounts for sale in West Bengal’s Malda!”, November 11, 2016

[xxxiii] See Khan (2012).

[xxxiv] See Rajakumar and Shetty (2016), p. 17.

[xxxv] See Posner (2000).

( Dr. Ashok Kumar Lahiri serves Chief Economic Adviser for Department of Economic Affairs of Ministry of Finance of India. Dr. Lahiri served as an Executive Director at Asian Development Bank.He serves as Chairman of Bandhan Bank Limited. This working paper submitted to the National Institute of Public Finance and Policy, New Delhi. )


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