Impact of India’s Demonetisation on Output, Welfare and the Shadow Economy

On 8 November 2016 it was announced that from midnight that night the two top denominations in India would no longer be legal tender. These two denominations represented 86% of the cash in circulation. A discussion paper from Monash Business School ¹ reviews findings from new modelling of that event that investigated the impact of that action on aggregate output, welfare and the size of the shadow economy in India.

The paper describes how payment choice is based on availability, usage, cost and effective taxes affecting consumption, distribution, aggregate output, welfare and the size of the shadow economy. The paper found that the welfare cost of the sudden demonetisation was a reduction of 1% in total consumption with its impact weighted to those with a higher dependency on cash who were less able to switch to non-cash payments.

When deciding between cash and non-cash payments, trade-offs are made. Cash carries a marginal cost based on the inconvenience and risks of holding it and the opportunity cost of lost interest which could be earned if it were in an account. Digital payments incur a usage cost, a higher effective tax rate and it can be constrained by the availability of the infrastructure. Digital payments require a bank account and along with that comes fixed fees for the use of debit cards. Since it is harder to evade tax with digital payments, the state receives more tax revenue from digital payments compared with cash payments. This is particularly true for low value transactions.

The demonetisation took place at a time of relative macroeconomic stability. Its impact was to reduce aggregate output and welfare. The study found that the aggregate welfare impact of the slow remonetisation was comparable to an inflation rate of 27.6%. This was not felt by the high consumption deciles because this group were already using digital payments extensively.

Equally the poorest in society were using low value banknotes and so the loss of the two high denomination banknotes had little impact. Average rural monthly consumption was Rs1,430 in 2011/12 compared with Rs2,630 in urban areas. While rural India has 35% of bank branches, it only accounts for 10% of bank deposits. One of the aims of the demonetisation, of course, was to increase the number of bank accounts and the use of digital payments. This was not covered in the paper.

The greatest impact was in the middle deciles, people who used the high denomination banknotes but who did not have bank accounts. Their ability to switch to digital payments was limited and so they ended up bearing the highest impact.

The modelling looked at how much consumers would be willing to give up in terms of total consumption in order to go back to the ease of pre-demonetisation payment systems. It found a decrease of 1.3% in consumption because of the slow and costly remonetisation exercise that took some months to do. The welfare cost of 10% inflation, compared with 0% inflation, is 0.3% of consumption and the welfare cost of 27.6% of inflation is 1.3% in consumption.

When the shadow economy was modelled, a rate of inflation of 10% saw the size of the shadow economy fall to 13% compared with 15% under 0% inflation. Although tax enforcement and, therefore, collection, rises on those transactions that switch to digital payments, it falls on transactions made with lower value denomination notes. In the calibrated model, the shadow economy fell from 15% to 12%.

The demonetisation represented a liquidity and payment system shock. In addition to the impact on consumption, welfare and the shadow economy described, the paper also found the demonetisation exercise had medium term aggregate and distribution consequences, a persistent fall in real economic outcomes and worse distribution outcomes contingent on the payment divides in society.

1 - ‘Consumer Payment Choice and the Heterogeneous Impact of India’s Demand’. Discussion paper 2021-15, Monash Business School. Ayushi Bajaj, Nikhil Damodarau.