Effect of Demonetization on Indian Economy | H&R Block | Blog
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Effects of Demonetization on Indian Economy

Effect on Demonetization

Some economists say demonetization will adversely impact India’s economic growth even as others believe the disruption is unlikely to be significant. Here is our take on how demonetization will impact Indian economy.

1) Effect on parallel economy

The removal of these 500 and 1000 notes and replacement of the same with new 500 and 2000 Rupee Notes is expected to hurt the parallel economy badly. It has the potential to remove black money from the economy as the owners will not be able to use it or deposit it in banks without attracting prosecution and penalty. It can halt the circulation of counterfeit currency which will curb the funding of terrorism and other anti-social elements.

2) Effect on Money Supply

With the older 500 and 1000 Rupees notes being scrapped, until the new 500 and 2000 Rupees notes get widely circulated in the market, money supply is expected to reduce in the short run. To the extent that black money does not re-enter the system, reserve money and hence money supply will decrease permanently. However gradually as the new notes get circulated in the market and the mismatch gets corrected, money supply will pick up.

 3) Effect on Demand

The overall demand is expected to be affected to an extent. 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)

These sectors will witness moderate deduction in demand from consumers due nature of transactions involved. Cash transactions form a significant part of transactions in these sectors.

[ Read: Demonetisation advantages and disadvantages ]

4) Effect on Prices

The moderation of demand can also bring down the prices of goods and services in general:

Consumer goods: Prices are expected to fall only marginally due to moderation in demand as people switch to using cards and cheques for some purchases. In the short term, prices of perishable goods could fall as transactions are largely cash based.

Real Estate and Property: Prices in this sector are largely expected to fall in the short and medium term, especially for sales of properties where major part of the transaction is cash based, rather than based on banks transfer or cheque transactions.

5) Effect on various economic entities

With cash transaction lowering in the short run, until the new notes are spread widely into circulation, certain sections of the society could face short term disruptions in facilitation of their transactions. These sections are:

  • Agriculture and related sector
  • Small traders
  • SME
  • Services Sector
  • Households
  • Political Parties
  • Professionals like doctor, carpenter, utility service providers, etc.
  • Retail outlets

The nature, frequency and amounts of the commercial transactions involved with these sections of the economy necessitate cash transactions on more frequent basis.

Thus, these segments are expected to have the most significant impact post this demonetization process and the introduction of new notes in circulation.

6) Effect on GDP

The GDP formation could be impacted by this measure, with reduction in the consumption demand. However with the recent rise in festival demand is expected to offset this fall in overall impact. Moreover, this expected impact on GDP may not be significant as some of this demand will only be deferred and re-enter the stream once the cash situation becomes normal.

7) Effect on Banks

As directed by the Government, the 500 and 1000 Rupee notes which now cease to be legal tender are to be deposited or exchanged in banks (subject to certain limits). This will automatically lead to more amounts being deposited in Savings and Current Account of commercial banks. This in turn will enhance the liquidity position of the banks, which can be utilized further for lending purposes. However, to the extent that households have held on to these funds for emergency purposes, there would be withdrawals at the second stage.

8) Effect on Online Transactions and alternative modes of payment:

With cash transactions facing a reduction, alternative forms of payment will see a surge in demand. Digital transaction systems, e-wallets and apps, online transactions using e-banking, usage of plastic money (debit and credit cards), etc. will definitely see substantial increase in demand. This should eventually lead to strengthening of such systems and the infrastructure required.

In spite of the initial hiccups and disruptions in the system, eventually this change will be well assimilated and will prove positive for the economy in the long run. Black money hoarders will definitely lose out, eventually boosting the formal economy in the long run. Short term fall in real estate prices might benefit middle class citizens. This move by the government along with the implementation of the GST will eventually make the system more accountable and efficient.

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CA Shreya Oturkar
CA Shreya Oturkar
Shreya is a tax advisor at H&R Block (India) with intensive experience in SME taxation and audit. She holds an advanced post graduate qualification in accounting and is highly skilled in financial analysis and reporting. Apart from her professional achievements, Shreya is a talented artist with a flair for free-hand sketching!