Demonetisation | ICSE Class 10 Economics Notes

This note covers demonetisation in India: what the term means, which notes were withdrawn in 2016, why governments demonetise, how the measure affects money supply, banking, prices and the digital economy, its benefits and limitations, and the difference between demonetisation and currency replacement.

What does demonetisation mean?

Demonetisation is the withdrawal by a government of the legal tender status of a currency unit. The notes or coins concerned stop being accepted as money for settling transactions. They lose their face value as a medium of exchange, though the holder may still be allowed to deposit or exchange them at banks for a limited period.

Definition: Demonetisation is the act of stripping a currency unit of its status as legal tender, so that it can no longer be used to buy goods, pay debts or settle transactions.

The key idea is that the currency is not abolished. New notes of the same or different denomination are issued, and the old ones are withdrawn. The measure therefore affects the stock of money in circulation and the way people hold and use money.

Demonetisation is different from devaluation. Devaluation lowers the external value of a currency against foreign currencies. Demonetisation changes the internal legal status of particular notes. It is also different from a simple currency replacement, where worn-out notes are swapped for new ones without any change in legal status.

Note: Demonetisation is a monetary measure. It is announced by the government, usually on the advice of the central bank, and it applies to the whole country at once.

What happened in India in November 2016?

On 8 November 2016 the Government of India announced that the ₹500 and ₹1,000 notes would cease to be legal tender from midnight. These two denominations made up about 86 per cent of the currency in circulation by value at that time. Holders could deposit the old notes in bank accounts, or exchange a limited amount for new notes, until 30 December 2016.

The legal route was a notification by the Government of India under Section 26(2) of the Reserve Bank of India Act, 1934, issued on the recommendation of the RBI's Central Board. India had demonetised high-value notes twice before: in 1946 (₹500, ₹1,000 and ₹10,000 notes) and in 1978 (₹1,000, ₹5,000 and ₹10,000 notes).

The Reserve Bank of India, the country's central bank, issued new ₹500 and ₹2,000 notes. The ₹2,000 note was a new denomination. Limits were placed on cash withdrawals and on the value of notes that could be exchanged over the counter, and these limits were revised from time to time.

The Reserve Bank later stopped printing the ₹2,000 note and, in May 2023, withdrew it from circulation, though it remains legal tender.

The stated aims were to curb black money, to strike at counterfeit currency used to fund illegal activity, and to push the economy towards digital payments. The government also linked the move to its campaign against corruption and terrorism financing.

Why do governments demonetise currency?

Governments usually give several reasons for demonetisation. Each reason rests on the idea that large holdings of cash are hard to trace.

1. To bring unaccounted or black money into the formal banking system, where it can be taxed.
2. To reduce the circulation of counterfeit notes used in illegal trade and terror funding.
3. To encourage a shift from cash to digital payments such as cards, mobile wallets and bank transfers.
4. To shrink the parallel economy that operates outside the tax net.
5. To improve the effectiveness of monetary policy by bringing more savings into banks.

The logic is that people holding large amounts of undeclared cash will either have to declare it, lose it, or face questions when they deposit it. Honest holders of small amounts are expected to be inconvenienced only briefly.

Definition: Black money is income on which tax has not been paid and which is not recorded in official accounts.

How does demonetisation affect money supply and banking?

Currency with the public is one component of the money supply. When notes lose legal tender status, the currency component falls until the old notes are replaced. If people deposit old notes in banks, the deposits component of money supply rises. The total money supply may therefore not fall by the full value of the withdrawn notes.

Banks receive a large inflow of deposits during the exchange window. This raises their liquidity, the funds available for lending. Banks may then lower deposit rates because they have more funds than they need, and lending rates may fall too. A fall in lending rates can encourage borrowing and investment.

Note: The effect on money supply depends on how much of the withdrawn currency is deposited and how much is never returned. Currency that is never exchanged is effectively destroyed and reduces money supply permanently.

Short-term disruption is likely in the cash-dependent parts of the economy. Traders, small firms, farmers and daily wage earners who deal mainly in cash may find it hard to pay wages or buy inputs until new notes reach them.

What are the advantages of demonetisation?

Demonetisation is defended on several grounds. The advantages are usually stated in terms of the formal economy, tax compliance and digital adoption.

• It brings a large volume of cash into bank accounts, making it traceable and taxable.
• It raises short-term deposits with banks and can lower interest rates.
• It reduces the stock of counterfeit notes in circulation.
• It encourages the use of digital payment methods and reduces dependence on cash.
• It signals a strong stand against black money and can improve tax compliance over time.

The gain to the exchequer comes from tax on deposits that cannot be explained, and from penalties on undeclared income. Over the longer term, a wider tax base can fund public services.

What are the limitations and disadvantages of demonetisation?

The measure also carries costs. Critics point to the disruption it causes and to the limits of what it can achieve.

• Most of the withdrawn notes are usually deposited back, so the amount of black money actually eliminated may be small. In India, the RBI's Annual Report for 2017-18 found that notes worth about ₹15.31 lakh crore, roughly 99 per cent of the ₹15.42 lakh crore withdrawn, had come back to the banking system.
• People who hold cash legally, especially the poor and those in rural areas, face hardship while new notes are scarce.
• Output and employment in cash-intensive sectors may fall in the short run.
• The cost of printing new notes and of managing the exchange is borne by the central bank and the government.
• Black wealth can be held in other forms, such as gold, property or foreign accounts, which demonetisation does not touch.

Note: The success of demonetisation is judged by how much unaccounted wealth is actually brought into the tax net, not simply by how many old notes are deposited.

How does demonetisation affect prices and the digital economy?

When cash is scarce, demand for goods and services may fall in the short run. A fall in demand can ease inflation, the rate of rise in the general price level. Sellers of perishable goods and of items bought mainly with cash may cut prices to attract buyers.

At the same time, the measure gives a push to digital payments. Mobile wallets, debit and credit cards, and the Unified Payments Interface (UPI) see a rise in use. Digital payments leave a record, which helps tax authorities and reduces the cost of handling cash.

What is the difference between demonetisation and other monetary measures?

Demonetisation is often confused with related measures. The table below sets out the differences.

Only demonetisation removes the legal tender status of a currency. The others change value, supply or condition of the currency without withdrawing its legal status.

Glossary

• Demonetisation: Withdrawal of the legal tender status of a currency unit by the government.
• Legal tender: Money that must by law be accepted in settlement of a debt.
• Black money: Income that is not declared and on which tax has not been paid.
• Money supply: The total stock of money, including currency with the public and bank deposits, in an economy.
• Liquidity: The ease with which an asset can be converted into cash without loss of value.
• Inflation: A sustained rise in the general price level of goods and services.
• Counterfeit notes: Fake currency notes printed to look like genuine ones.
• Parallel economy: Economic activity that takes place outside official records and the tax net.
• Devaluation: A fall in the external value of a currency against other currencies.
• Digital payments: Payments made electronically through cards, wallets or bank transfers.
• Central bank: The apex bank of a country, which issues currency and regulates banks.
• Face value: The value printed on a note or coin.

Common errors and misconceptions

• Misconception: Demonetisation means the notes are banned forever. Correct: It withdraws legal tender status; new notes are issued and the old ones may be exchanged for a period.
• Misconception: Demonetisation and devaluation are the same. Correct: Devaluation lowers the external value of the currency; demonetisation removes the legal status of particular notes.
• Misconception: Demonetisation destroys all black money. Correct: It affects black wealth held as cash; wealth held as gold, property or abroad is untouched.
• Misconception: Money supply falls by the full value of withdrawn notes. Correct: Deposits rise as notes are deposited, so the fall in total money supply may be smaller.
• Misconception: Only the central bank can demonetise. Correct: The government announces it, usually on the advice of the central bank.
• Misconception: Demonetisation has no cost. Correct: It involves printing costs, disruption to cash-intensive activity and hardship for cash users.

Exam-style questions with model answers

Q1. Define demonetisation. [2 marks]

1. Demonetisation is the withdrawal by the government of the legal tender status of a currency unit.
2. The notes concerned can no longer be used to settle transactions, though they may be exchanged at banks for a limited period.

Q2. State two reasons why governments demonetise currency. [2 marks]

1. To bring unaccounted or black money into the formal banking system where it can be taxed.
2. To reduce the circulation of counterfeit notes used in illegal activity.

Q3. Explain how demonetisation affects money supply and bank deposits. [4 marks]

1. Currency with the public is one component of money supply; when notes lose legal tender status, this component falls.
2. If holders deposit old notes in banks, the deposits component of money supply rises.
3. The total money supply may therefore not fall by the full value of the withdrawn notes.
4. Currency that is never exchanged is effectively destroyed and reduces money supply permanently.

Q4. Distinguish between demonetisation and devaluation. [3 marks]

1. Demonetisation withdraws the legal tender status of particular notes; devaluation lowers the external value of the currency against foreign currencies.
2. Demonetisation changes the internal legal status of notes; devaluation changes the exchange rate.
3. Demonetisation affects the currency in circulation and bank deposits inside the country; devaluation makes imports dearer and exports cheaper for foreign buyers.

Q5. Discuss the advantages and limitations of demonetisation. [5 marks]

1. Advantage: it brings a large volume of cash into bank accounts, making it traceable and taxable.
2. Advantage: it raises short-term deposits with banks and can lower interest rates.
3. Advantage: it reduces counterfeit notes and encourages digital payments.
4. Limitation: most withdrawn notes are usually deposited back, so the black money actually eliminated may be small.
5. Limitation: cash users, especially the poor and rural households, face hardship, and cash-intensive output and employment may fall in the short run.

Q6. How does demonetisation affect prices and digital payments? [4 marks]

1. When cash is scarce, demand for goods and services may fall in the short run.
2. A fall in demand can ease inflation, the rate of rise in the general price level.
3. The measure gives a push to digital payments such as cards, mobile wallets and bank transfers.
4. Digital payments leave a record, which helps tax authorities and reduces the cost of handling cash.

Key takeaways

• Demonetisation withdraws the legal tender status of a currency unit, so the notes stop being accepted as money.
• India withdrew the ₹500 and ₹1,000 notes from midnight of 8 November 2016 and issued new ₹500 and ₹2,000 notes.
• Governments demonetise to curb black money, counterfeit notes and the parallel economy, and to push digital payments.
• Money supply may not fall by the full value of withdrawn notes because deposits rise as notes are banked.
• Banks gain liquidity, which can lower deposit and lending rates and encourage borrowing.
• Cash-intensive sectors and poor households bear much of the short-term cost of the measure.
• Black wealth held as gold, property or abroad is not touched by demonetisation.
• Demonetisation differs from devaluation, which changes the external value of the currency.

Test yourself

What is legal tender?

Legal tender is money that must by law be accepted in settlement of a debt. When notes lose this status, they can no longer be used to settle transactions.

Which notes were withdrawn in India in November 2016?

The ₹500 and ₹1,000 notes ceased to be legal tender from midnight of 8 November 2016. New ₹500 and ₹2,000 notes were issued.

Why may money supply not fall by the full value of withdrawn notes?

Because holders deposit old notes in banks, which raises the deposits component of money supply. Only currency never exchanged reduces money supply permanently.

How does demonetisation affect bank liquidity?

Banks receive a large inflow of deposits during the exchange window, which raises their liquidity, the funds available for lending, and may lower interest rates.

Name one limitation of demonetisation.

Most withdrawn notes are usually deposited back, so the amount of black money actually eliminated may be small. Black wealth held in other forms is untouched.

How is demonetisation different from currency replacement?

Currency replacement swaps worn-out notes for new ones without any change in legal status. Demonetisation removes the legal tender status of the notes.