DEMONETIZATION
1. What is Demonetization?
Demonetization is the act of stripping a currency unit of its status as legal tender. It occurs whenever there is a change in national currency. The current form or forms of money is pulled from circulation and retired, often to be replaced with new notes or coins. Sometimes, a country completely replaces the old currency with a new currency.
1.1 Key Takeaways
- Demonetization is a drastic intervention into the economy that involves removing the legal tender status of a currency.
- Demonetization can cause chaos or a serious downturn in an economy if it goes wrong.
- Demonetization has been used as a tool to stabilize the currency and fight inflation, facilitate trade and access to marks, and push informal economic activity into more transparency and away from black and gray markets.
- A famous example of demonetization occurred in 2016 when India demonetized 86% of its nation's currency.
- Demonetized may also refer to social media or digital content that formerly qualified for revenue distribution but has since been denied income proceeds.
2. Understanding Demonetization
- Removing the legal tender status of a unit of currency is a drastic intervention in an economy because it directly affects the medium of exchange used in all economic transactions. It can help stabilize existing problems, or it can cause chaos in an economy, especially if undertaken suddenly or without warning. That said, demonetization is undertaken by nations for several reasons.
- Demonetization has been used to stabilize the value of a currency or combat inflation. The Coinage Act of 1873 demonetized silver as the legal tender of the United States, in favor of fully adopting the gold standard, to stave off disruptive inflation as large new silver deposits were discovered in the American West. Several coins, including a two-cent piece, three-cent piece, and half-dime were discontinued.
- In a more modern example, the Zimbabwean government demonetized its dollar in 2015 as a way to combat the country's hyperinflation.
- Some countries have demonetized currencies to facilitate trade or form currency unions. An example of demonetization for trade purposes occurred when the nations of the European Union officially began to use the euro as their currency in 2002.
3. Pros and Cons of Demonetization
Pros
- Often resulting in decreased tax evasion and decreased tax revenue.
- Often results in higher long-term GDP due to higher tax revenue being reinvested in the nation.
- Fosters innovation by converting currency to digital currency and promoting digital transactions.
- Reduces overall crime by enhancing transparency and discouraging the circulation of black money.
Cons
- Imposes a burden on citizens, especially those who must convert one currency to another.
- It likely stalls a nation's GDP during the conversion process.
- Incurs expensive administration costs including printing, adjusting ATMs, and marketing the changes.
- Negatively impacts and even stops cash-driven sectors.
- Introduces new types of currency risk such as cybercrime.
4. Demonetization example in India
- Lastly, demonetization has been tried as a tool to modernize a cash-dependent developing economy and to combat corruption and crime (counterfeiting, tax evasion). In 2016, the Indian government decided to demonetize the 500 and 1000 rupee notes, the two biggest denominations in its currency system; these notes accounted for 86% of the country's circulating cash.
- India's Prime Minister Narendra Modi announced to the citizenry on Nov. 8, 2016, that those notes were worthless, effective immediately- and they had until the end of the year to deposit or exchange them for newly introduced 2000 rupee and 500 rupee bills.
5. Why could a country Demonetize?
Demonetization has been used to stabilize the value of a currency or combat inflation. Some countries have demonetized currencies to facilitate trade or form currency unions.
Lastly, demonetization has been tried as a tool to modernize a cash-dependent developing economy and to combat corruption and crime (counterfeiting, tax evasion).
6. Advantages of Demonetization
The main benefit of demonetization is to curtail criminal activity as their supply of money is no longer legal tender. This affects counterfeiters as well as they cannot exchange their "merchandise" for fear of discovery. It can prevent tax evasion as those who were evading taxes must come forward to exchange their existing currency at which time the authorities can retroactively tax them. Finally, it can usher in the digital currency age by slowing down the circulation of physical currency.
7. Disadvantages of Demonetization
The chief disadvantage is the costs involved in printing and minting the new currency. Also, demonetization may not have the intended effect of reducing criminal activity as these entities might be savvy enough to hold assets in other forms other than physical currency. Finally, this process is risky as it can plunge the nation into utter chaos if not handled with the utmost competence.
8. Impact of Demonetization on GDP
In the short term, demonetization usually stunts economic growth and causes GDP to decline.
During the conversion process, many industries and sectors may temporarily come to a halt. Some industries may not be able to pay laborers as the demonetization process occurs.
Once demonetization is finished, it often creates long-term economic benefits that increase GDP in the long run. Demonetization attempts to fight financial crime; by making transactions more transparent or discouraging the trade of illegal bills, a government is usually able to collect more tax revenue and invest heavier in their country.
For Mains:
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1. What is demonetization? Explain the impact of Demonetization on the Indian Economy.
2. What steps might be required as a follow-up to demonetization, to check the re-emergence of black money in India?
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