The raging debate around demonetisation has an interesting relief - the inability of the commentariat (bankers, media, economists, astrologers, bhakts - in no particular order or mutually exclusive category) to say, "I dont know". We have had revised GDP forecasts (an investment bank predicted a 3% hit, based on a bizarre conflation of high powered money and broad money. Ex-PM Manmohan Singh predicted a 2% hit, basis, well nothing that he cared to elaborate). We have also had pop sociology in full flow, with assorted bhakts claiming this is a "revolution" of society and economy together - recently departed Castro would approve!
Issue though is, economically, demonetisation in this scale (and economic stage) is so unprecedented that its difficult to see how any of these numbers are even ca lculated, forget being credible. As Niranjan Rajadhyaksha described in his column, demonetisation is a natural experiment, albeit one on a very large scale and hence inherently risky. What are the issues in this case in deriving assumptions on economic outcomes? Lets see it at a basic level.
The essential monetarist view of GDP is explained by the following equation:
M X V = P X Q, where
M: Money supply in the economy (the total amount of currency notes and bank deposits circulating in the economy)
V: Velocity of Money (number of times a rupee of cash/deposit circulates in the economy per year)
P: Price levels in the economy
Q: Volume of Output in the economy
From a monetarist perspective, how inflation (P) and GDP (output, Q) behave is a function of the changes in M and V.
Now lets see what happens as a result of demonetisation to each of these variables.
Money supply (M) gets an upfront negative shock, as the RBI on 8th Nov withdrew ~14 lac crores of banknotes, accounting for ~12% of total M in the economy. This, taken on its own is a significant monetary contraction, and should result in interest rates shooting up (interest rate is the price of M, if supply of M goes down, price should go up). However, on the other hand, withdrawal of banknotes has been accompanied by a huge accretion of deposits as people have been asked to swap their banknotes for deposits in the bank. Now, a rupee in deposits adds a lot more to M than a rupee in banknotes (due to a concept called money multiplier). As a result, interest rates should decline (as M goes up with banknotes being replaced by deposits). Net net, we have two counteracting forces - one that is pulling M down, while the other is pushing M up. As of now, interest rates have actually come off drastically (and somewhat counter-intuitively), but how things will stabilise in the medium term - there isnt sufficient data yet to conclude.
Velocity of money (V) gets an upfront negative shock too, with cash being such an important medium of commercial transaction in the economy. Additionally, with new banknotes primarily coming in the form of the new 2000 rupee notes (that are difficult to "break"), V declines further, as the new notes are circulated less number of times than the same value of old notes could be. A reduction in V causes a decline in GDP (given all other things constant). However, a move, both forced and behavioral towards more cash-less modes of transaction (UPI/wallets/cards etc) tend to increase V, as electronic cash has greater V than physical cash. Increase in V accelerates GDP. There again, we have two counteracting trends emerging. Net net, how will this play out? We dont know (yet), too early to conclude in absence of data.
The most ubiquitous principle used by economists is that of ceteris paribus, or, all other things remaining constant. The ability to predict outcomes is dependent on the ability to fix the level of input variables. In the best of situations its an impossible condition to meet (a prime reason why astrology is often said to have better predictive powers than economics). In a massive real-time natural experiment of the sort we have in demonetisation, it is really besides the point to even consider.
In effect, the biggest point is, whether on interest rates, or inflation, or GDP growth - the impact is undetermined and as yet, undeterminable. The best answer that most folks could credibly have is "I dont know". But saying "I dont know" requires a level of humility missing entirely from our 24/7 commentariat.
Issue though is, economically, demonetisation in this scale (and economic stage) is so unprecedented that its difficult to see how any of these numbers are even ca lculated, forget being credible. As Niranjan Rajadhyaksha described in his column, demonetisation is a natural experiment, albeit one on a very large scale and hence inherently risky. What are the issues in this case in deriving assumptions on economic outcomes? Lets see it at a basic level.
The essential monetarist view of GDP is explained by the following equation:
M X V = P X Q, where
M: Money supply in the economy (the total amount of currency notes and bank deposits circulating in the economy)
V: Velocity of Money (number of times a rupee of cash/deposit circulates in the economy per year)
P: Price levels in the economy
Q: Volume of Output in the economy
From a monetarist perspective, how inflation (P) and GDP (output, Q) behave is a function of the changes in M and V.
Now lets see what happens as a result of demonetisation to each of these variables.
Money supply (M) gets an upfront negative shock, as the RBI on 8th Nov withdrew ~14 lac crores of banknotes, accounting for ~12% of total M in the economy. This, taken on its own is a significant monetary contraction, and should result in interest rates shooting up (interest rate is the price of M, if supply of M goes down, price should go up). However, on the other hand, withdrawal of banknotes has been accompanied by a huge accretion of deposits as people have been asked to swap their banknotes for deposits in the bank. Now, a rupee in deposits adds a lot more to M than a rupee in banknotes (due to a concept called money multiplier). As a result, interest rates should decline (as M goes up with banknotes being replaced by deposits). Net net, we have two counteracting forces - one that is pulling M down, while the other is pushing M up. As of now, interest rates have actually come off drastically (and somewhat counter-intuitively), but how things will stabilise in the medium term - there isnt sufficient data yet to conclude.
Velocity of money (V) gets an upfront negative shock too, with cash being such an important medium of commercial transaction in the economy. Additionally, with new banknotes primarily coming in the form of the new 2000 rupee notes (that are difficult to "break"), V declines further, as the new notes are circulated less number of times than the same value of old notes could be. A reduction in V causes a decline in GDP (given all other things constant). However, a move, both forced and behavioral towards more cash-less modes of transaction (UPI/wallets/cards etc) tend to increase V, as electronic cash has greater V than physical cash. Increase in V accelerates GDP. There again, we have two counteracting trends emerging. Net net, how will this play out? We dont know (yet), too early to conclude in absence of data.
The most ubiquitous principle used by economists is that of ceteris paribus, or, all other things remaining constant. The ability to predict outcomes is dependent on the ability to fix the level of input variables. In the best of situations its an impossible condition to meet (a prime reason why astrology is often said to have better predictive powers than economics). In a massive real-time natural experiment of the sort we have in demonetisation, it is really besides the point to even consider.
In effect, the biggest point is, whether on interest rates, or inflation, or GDP growth - the impact is undetermined and as yet, undeterminable. The best answer that most folks could credibly have is "I dont know". But saying "I dont know" requires a level of humility missing entirely from our 24/7 commentariat.
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