By?Jatin Bavishi?
A lot of ink has already been spilt over the alleged impact, rationale and reason over the decision of the present government to cease backing Rs 500 and Rs 1000 notes as legal tender. Although the whole episode resulted from a dramatic culmination of myth and opinion, this is not the first time a government has withdrawn fiat currency. But, if history is ever a guide, these actions usually arise as a means to tackle hyperinflation, low growth or political instability.
India does not grapple with any of these at present. Therefore, this experiment seems novel. In 1978, the 5000 rupee currency note was pulled out, but it can be assumed that the proportion of people who had the purchasing power to hold such a sum back then was limited. To put things in perspective, the GDP per capita in 1978 was Rs. 690, according to the Economic Survey of 1978-79.
Marrying currency and inflation
The status quo is a bit different now and there has been a leap in the overall economic consensus. Governments broadly have two policy measures at their disposal: Monetary and Fiscal. Since the 1980?s, the former has assumed greater significance over the latter. This was partly enabled by academics, who augmented its role by theorizing the superiority of ?rule-based market mechanism? versus a ?discretion-based bureaucratic allocation?.
According to economist Mihir Rakshit, the dismantling of the ?fixed exchange rate? regime, which gave more room for monetary policy to operate, was also an important reason. At the same time, ?targeting inflation? became the holy sacrament of prudentiality. Theoretically, money supply (meaning the currency notes in circulation) and inflation have a positive correlation. A contractionary monetary policy, by reducing money in the hands of the people, is an effective tool to curb inflation.
Regulation and stagnation
There is an asymmetry in the effectiveness with which Central Banks can conduct its monetary policy under inflation and deflation. Specifically, during inflation, plenty of policy instruments are available to cool the economy at the regulator?s disposal. During deflation however, the options are reduced since the quantum of currency in circulation impacts the rate of interest. There is also a natural limit below which these rates cannot fall. This stagnation occurs around the sub-zero interest rate level.
The global economy post 2008 is still languishing in important areas while the interest rates are already circling zero in most ?developed? countries. To give more teeth to the Central Banks, academics are pushing forward the idea to exhaust the ?institution of cash? entirely so that this apparent asymmetry ceases to exist (with added emphasis in ?developed? countries).
Bribing national interest
Even within the ambit of Fiscal Policy, the role of Central Banks has been reduced to maintaining fiscal deficits, or other such percentages under control. There is also a change in the medium of fiscal intervention which has been increasingly routed through the money market. India has been lured into these trends. Budgets and other policies over the past few years have been preceded by pleasing people with good interest rates rather than outright public expenditure. The logic behind going cashless should be understood in this context.
Hence, demonetisation move was not a shot in the dark and has definite theoretical underpinnings. However, as has already been pointed out, such a move would be better suited under very different contexts. The idea isn?t flawed; just the execution.
Featured image source: Pixabay
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