Macroeconomicsof India’s Currency Reforms
Macroeconomicsof India’s Currency Reforms
Thereis an extensive literature on the modern institutional approach tothe analysis of real life economic policies. The most commonliterature topic is on the application of economic models to theanalysis of economic policies. Economic models are theoreticalconstructs that represent economic processed by some variables aswell as logical quantitative relationships between the variables.They are simplified frameworks that are designed to illustratecomplicated processes using mathematical techniques such as graphs.An example of such a model is the IS/LM model. Models have variousparameters which change to create different properties. This essayexplores the effect of the change in the economic policy of India.The event is the demonetizing of the 500 and 1000 rupee notes byIndia`s Prime Minister, Narendra Modi. The IS/LM model is applied todetermine the effect of the economic policy change on lending ratesand other aspects of India’s economy.
Overviewof India’s economy
Thecombination of import-substitution, protectionist, Fabian socialism,social democratic-inspired policies have governed India for a longtime since the end of British colonization of the country. At thattime, the economy was characterized by protectionism, extensiveregulation, pervasive corruption, public ownership of largemonopolies and slow growth. However, since the 1990s the increase ineconomic liberalization has seen the country move towards a moremarket-based economy. By the year 2008, the country had establisheditself as one of the fastest rising economies. Growth significantlydecelerated to 7.0% in the financial year 2008-09, but subsequentlyrecovered to 7.4% in the financial year 2009-10. In the same period,the fiscal deficit increased from 5.9% to a high of 6.5%. Accordingto the Government of India’s Labor Bureau, the unemployment rate in2012-13 was reported as 4.7% across the nation by UPS method and 3%by NSSO method (Kumar, 2013). The consumer price inflation rangedfrom 8.9 to 12% over the period between 2009 and 2013.
India’seconomy is considered the seventh largest economy in the whole worldwhen using measurements by nominal GDP and the third largest whenusing purchasing power party (PPP). The country is categorized as anewly industrialized country that is among the G-20 economies. It isalso classified as a developing country with an approximate averagegrowth of 7% over the past twenty years. In the most recent report,the country recorded a GDP of $2.25 trillion (nominal) and $8.72trillion (PPP) in the year 2016 (International Monetary Fund, 2014).This was in the fiscal year that lasted from 1stApril to 31 March. This resulted in a GDP growth of 7.6% from theyear 2015. The long-term economic growth prospects of the country arepositive mainly because of its young population, healthy savings, lowdependency ratio, and increased incorporation into the globaleconomy. According to IMF, the country also has a positive short-termeconomic growth with an expected rise of 8% in the financial year2016-17. It is also worth noting that India has one of the fastestgrowing service sectors across the world and which records an annualgrowth rate of over 9% since the year 2001 (Schneider, 2015).
Source:Reserve Bank of India (2016).
Overviewof the particular event
OnNovember 8th,2016, India`s government announced that it would ban the existing 500and 1000 rupee notes (Doshi & Allen, 2016). These are thecountry’s largest denominations with the 500 notes worthapproximately $7.50 and 1000 notes worth about $15. It is estimatedthat this currency accounts for over 86% of the value of all cashthat is in circulation in the country. Since the announcement, mostpeople have rushed to convert their cash holdings into newdenominations. This saw an increase in queues in banks and ATMs.According to the announcement, the citizens of the country areallowed to deposit or exchange these currency notes in banks, postoffices for a period that lasts until the end of the year. The noteswere also not usable in other sectors except in pharmacies andhospitals for the following few weeks. The government also informedthe people that they would be initially restricted from withdrawingmore than Rs 2,000 in a day from banks or cash machines with thelimit increased to Rs 4,000 from 19thNovember (Doshi & Allen, 2016).
Thepurpose of this ban was to undercut counterfeiters and combatcorruption as well as other crimes that rely on paper money. The moveis the latest step by India’s Prime Minister, Mr. Narendra Modi,and his administration to crack down on the shadow economy that isnot liable to taxation by India’s tax authorities (Kazmin &Mundy, 2016). It is said that many Indians are sitting on piles ofcash that they got from illegitimate activities. Such cash is used tofinance corruption of high levels in the country. The move is set toscare people holding money with illicit intentions and by doing sospur a move towards more effective electronic payment systems. Themove comes after the expiry of a four-month amnesty period for taxevaders, who had declared a $9.8 billion amount of undisclosedassets, to pay a penalty of 45%. The government had promised to takestern actions on these people who had failed to declare their blackmoney or bring it back into the country’s financial system. However, it is important to note that many ordinary poor Indians inrural areas also keep their savings in paper currency (Soutik, 2016).
Source:McKinsey & Company (2013)
Analysisof the India’s currency reforms
Theincreased demand for money shifts the LM curve up as shown in thegraph above. This would result in reducing inflation as was the casefor India. The policy to demonetize 500 and 1000 rupee notes resultsin low amounts of money in circulation. From the IS-LM curve model,it is seen that decrease in money supply leads to a decrease inaggregate demand for goods and services. This is what affectedtraders in India immediately after the announcement by thegovernment. People were not able to buy goods as the demand was lowdue to lack of money. This decrease in aggregate demand leads tolower inflation rates.
Oneof the main reasons that the government gave for demonetizing the 500and 1000 rupee notes is to curb financing of terrorism or any othersubversive activities using fake currency notes. I believe that thisis true for the country of India. The move is also aimed atrestraining the shadow economy in the country which is the majordriver of inflation. Inflation adversely affects the poor people anddeprives the government if its tax revenue. Because there will be asmaller supply of money, inflation will be reduced (Worstall, 2016).The reduction of cash circulation in the country would also ensurethat corrupt and illegal activities that are carried out by use ofcash will be eliminated. The move will unearth the citizen’s realincome and ensure that they pay their taxes appropriately. This willbe very helpful for a country which currently has only 5.5 percent ofits working population paying taxes and about 85 percent of thecountry’s economy is outside the economy net. The country’s GDPratio is only 16.6 percent, which is about 5.4 percent less thanpoints of comparable countries.
Onepositive macroeconomic effect of demonetizing the 500 and 1000 rupeenotes is the lowering down of interest rates. State Bank of India(SBI) has reduced rates down by 15 basis points from one year to 455days on deposits to 6.90% while maintaining the 7% rate for depositsfor periods ranging between 211 days and one year (Worstall, 2016).This will have the effect of lowering lending rates in the ensuingperiod. This would boost the credit expansion department and shore upgrowth. According to Worstall, 2016, the SBI chairman, BhattacharyaArundhati, stated that all rates will fall as the bank hasexperienced a large inflow of deposits and less demand for credit.The consequent little drop in lending rates will produce a stimulusto the economy.
Themove by Mr. Modi has also had its shortcomings. The shock moveresulted in a majority of people panicking. The period following theannouncement saw long queues in banks and ATMs as people attempted todispose of the 500 and 1000 rupee notes. Fistfights even developed inthese lines as clerks ran out of other cash denominations. The pricesof gold and silver soared as investors sought to move their moneyinto tangible assets (Ghosh, 2016). The negative effects of the grandplan by the government had been worsened due to ineptitudeimplementation. There is no enough new currency available in thecountry and ATMs are empty while banks have been stretched to beyondtheir capacity (Ghosh, 2016). The problem has gone beyond mereinconvenience as lack of cash has also resulted in a reduction inconsumption and demand. This has a knock-on effect on traders’incomes, sales, production, and in employment. Traders are losing alot of perishable stocks while daily laborers are not able to findjobs. Small producers are not able to get working capital from thelenders that they normally use. Farmers are also much affected by themove as their harvested crops are not being sold. This makes themunable to purchase inputs that they would use in the coming plantingseasons. They cannot afford to bear with the temporary setback as thegovernment had beseeched them because they stand to lose everything.
Itis true that this demonetization of 500 and 1000 rupee notes by thegovernment could hurt the economy in the short-term, but it hasultimate positive results. However, the sudden cash will have adverseeffects on the country’s economy initially. It is true that grocerytraders have experienced declines in their businesses (Soutik, 2016).The transport sector is also adversely affected as drivers are notable to pay the toll booth fees. Some of the ultimate benefitsinclude cutting down corruption and providing the government withadequate funds to run the country. The move would also cut down onproperty prices where most transactions are in cash. It is estimatedthat there would be a 50 percent correction in residential realestate prices. It is also important to note that the impact of thenegative effects of this move depends on how fast the governmentrolls out replacement cash. As expected, the process was agonizinglyslow at first with ATMs needing physical recalibration to handle newnotes.
Indiais not the first country to introduce abrupt and drastic reforms toits currency. Previous attempts by Burma in 1987, the Soviet Union in1991, and North Korea in 2009 all had devastating consequences.People of North Korea went hungry, Burma erupted in revolt and theSoviet Union disintegrated. So, Modi had to ensure carefulpreparations before demonetizing the 500 and 1000 rupee notes. As hasbeen discussed, India experienced economic pressure immediately theannouncement was made. There was a lack of money for most people inthe country and this hindered their ability to buy basic commodities.However, the essay has also shown that there would be many positiveresults in the long term. For instance, there would be a reduction inlarge cases of corruption, the rate of inflation will also bereduced, the government would get enough money to finance itsactivities through the increase in taxation and the country`s economywould also improve
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