The Dangers of Playing With Money Supply

The ripple effects of demonetisation are only beginning to show. If the cash crunch continues, production, employment and investment will be affected in both the informal and formal sector.

Monetary contraction is known to slow down economic activity. Credit: Reuters

Monetary contraction is known to slow down economic activity. Credit: Reuters

The demonetisation of high denomination notes is now largely being seen as an ill planned move by the Indian government. The government has been criticised over the hardship that common people are facing and the effect the move has had on the informal sector. Some have also pointed out that the government did not think about the needs of production activities. However, even the critics of demonetisation seem to think that everything will be back to normal after the supply of money is restored. The damage resulting from the cash crunch due to demonetisation may not seem grave at this moment, but these may increase beyond the present estimates if the ongoing problems persist in December as well.

Monetary contraction is known to slow down economic activity. The monetarists believe that monetary contraction is the main reason a normal recession turned into the Great Depression in the US in the 1930s – the quantity of money in the economy reduced by one-third between 1929 and 1933. In contrast, demonetisation has removed 86% of all currency from the Indian economy, which will only be restored in about six months. Even though demonetisation is not the same as the monetary contraction that happened in the US, the two are likely to have the same effects. The fact that the government plans to replace currency notes does not make any difference as far as its effect on economic activity is concerned. Studies have suggested that the effect of the change in money supply is often observed on the real economy after a lag. This is because it takes time for the money supply to start affecting economic activities and the effect often travels from one sector to the other over time. We may expect a similarly lagged effect here too. To understand this effect, we need to know the immediate effects of demonetisation and then think about how these may be transmitted to other sectors, causing distress in the economy.

In an economy, consumption, production and investment activities are so linked that not only does a decline in one of these adversely impact the other two, but this effect also travels back to intensify the original decline. As a result, a strong negative shock in one of these activities may push the economy to a situation similar to a recession. Even when such effects begin in a few sectors, they soon spreads to other sectors owing to their ripple effect. The present demonetisation has the potential to create such an effect.

It is almost clear at this point of time that demonetisation has resulted in a significant decline in demand in the informal sector (as it heavily depends on cash payments). In addition, it has also affected production activities in the informal sector. This is the first ripple created by demonetisation. If the decline in consumption and production during any period just means postponement of consumption and production (so no effect on actual consumption and production), then the effect of such a move is minimal. For example, one can postpone the purchase of a television. However, this is not the case for all commodities. For instance, one cannot start eating more in restaurants once money supply is restored to the old level. Similarly, if a person lowers her demand for telecommunication services in one period, then there is no reason for her to increase her demand for it in the future. A consumption shock will lower demand for a large number of products. This decline in demand will have bearings on the income of all those who are involved in the production and distribution of these commodities – producers, workers, transporters, whole sellers, retailers and so on. News reports suggest that people’s incomes, especially in the informal sector, have been severely hit post demonetisation. The government has worsened the situation by putting a limit on withdrawals, leading to people further lowering their consumption.

The situation would have started easing if demonetisation had hit consumption alone. However, it has also created a problem for producers. Producers (as already suggested by people like Pronab Sen) often need a large chunk of money. The lack of cash has hampered production activities in the informal sector, which mostly depend on cash transactions. In fact, Subramanian Swamy (while claiming that the rich are also suffering) talked about a rich transporter who is unable to send his trucks as each driver needs about Rs 45,000 for a journey. This shows that the formal sector is also not fully immune from the negative effects of demonetisation. The effect on production activities also means a decline in the incomes of people working in these sectors.

Considering these effects, one can expect significant decline in the incomes of people. If we assume that only the informal sector (which is about 45% of GDP) has been hit and demand in this sector has declined about 20%, then one can expect about a 9% decline in GDP in November and December. These estimates are likely to be much lower than the actual damage, as some news reports suggest more than a 40% decline in demand for some businesses. In addition, the income of the farmer has also been hit due to a decline in the price of agricultural products.

Though many have observed these damages, they seem to think that this effect on incomes in the informal sector is not going to affect the formal sector. However, decline in informal sector income has a direct bearing on the demand for formal sector products. For example, a large part of the demand for telecommunication services, electronic products, automobiles and so on comes from households which depend on the informal sector for their income. A decline in their income will mean lower demand for the products of the formal sector, which in turn lowers the production and profits of the formal sector. This will be the second ripple created by demonetisation.

The third ripple will be in terms of the potential effect of demonetisation on employment and investment. The decline in demand as well as profits in the formal and informal sector is likely to force firms to delay their investments. Lower investment will further lower employment and incomes, thus intensifying the original negative effect.

The fourth ripple may be in terms of an increase in non-performing assets (NPAs). Declining profits and increased unemployment may also make bank loan repayment difficult. Firms take loans in anticipation of future demand for their products. The decline in demand due to unanticipated shock is likely to make it difficult for them to repay loans. Further, increased unemployment and lower household income may force many households to default on their loans. This may increase pressure on the Indian banking system, which is already struggling due to the high number of NPAs.

Demonetisation has already done some damage, which is likely to increase in the coming days. Since the flow of these effects from one sector to another takes time, the major effect of this move on consumption and formal sector production may not be immediately observed. However, it may be too late if the government waits for these effects to appear before acting – and the government may end up spending the rest of its term undoing the damage done by demonetisation.

Indervir Singh is assistant professor in the department of economics and public policy, Central University of Himachal Pradesh.

  • vijay

    r footings it will be very difficult to control it later . PM should be apprised of Ground Realities and remedial action Taken