Download Macroeconomic Effects of Demonetization in India: Policy

Macroeconomic Effects of Demonetization
in India: Policy Simulations using a Macro
Econometric Model for India
KN Murty
Professor (Retd.), School of Economics, University of Hyderabad
Currently:
Adjunct Faculty, CR Rao AIMSCS, HCU Campus, Hyderabad
Email: [email protected]
Introduction:

On 8 November 2016, Prime Minister Sri Narendra Modi has
announced the withdrawal of all currency notes of Rs. 500
and Rs. 1000 denomination issued by the Central Bank
from circulation with immediate effect.

However, some provision was made to exchange/deposit
these currency notes through banking channel for a
limited period to facilitate public transactions.

The demonetized currency has also been permitted for
specified purposes for some extended period.

The proclaimed purpose of this important measure is to
curb/unearth large amount of ‘black money’ (and also
‘fake’ currency) accumulated over time in the Indian
economy.

The characterisation of ‘black money’ is like the story of
an ‘elephant and group of blind persons’. It depends on
the imagination of the beholder!

There are widely varying estimates of this ‘black money’to the tune of (30-50%) of official money supply.

The present demonetisation of money supply in the
economy is a very significant measure by the GoI/RBI.

Till date, despite the best efforts by the central bank and
the entire banking system to meet the day-to-day
currency needs in the country, there has been widespread
discontent (and some cautious acclaim as well) from
different sections of the population due to the nonavailability of replacing currency notes in adequate
quantity/value.



The central bank and the govt. has been assuring the
nation that the shortage of currency notes is certainly
temporary and the ‘demonetization’ exercise is very much
essential to improve the efficiency of the economic
system.
The purpose of this paper is to quantify the likely
macroeconomic effects of this measure on the Indian
economy.
Based
on
an
estimated
integrated
structural,
simultaneous, medium-sized macro econometric model for
India, counter-factual simulations relating to a one-period
(shock) reduction in money supply coupled with oneperiod increase in bank deposits and one-period increase
in direct tax collections are undertaken. We use the
‘narrow’ or reserve money aggregate for this purpose.



Since the RBI is expected to bring into circulation newly
printed currency notes of Rs. 500 and Rs. 2000
denominations to replace the old currency in the
economy, the overall money supply situation is
continuously evolving at the moment.
The present exercise is therefore an attempt to
understand this complex monetary-fiscal scenario and
make some scientific guesses about macroeconomic
impacts of ‘Demonetization’ in India.
The paper uses an econometric model that was estimated
for 1985-’86 to 2009-’10 annual time series data. The
estimated model shows significant macroeconomic
linkages between different sectors contemporaneously
and over time in Indian economy.

Four counter-factual scenarios are attempted, viz.
 (a)
One-period (shock) 5% reduction in reserve money
amounting to roughly Rs. 5,000 crores, symbolising
‘black money‘, which could not be brought back into
circulation after permanent withdrawal of Rs. 500 and
Rs. 1000 notes from circulation.
 (b)
50% one-period increase in deposits with
commercial banks (Rs. 1,25,000 crores approximately).
 (c)
 (d)
Scenario (a) and (b) together.
Scenario (c) with 30% one-period increase in direct
taxes (Rs. 5,000 crores approximately).

Since the demonetisation process is still incomplete, the
proposed counter-factual changes are hoped to be
plausible, though somewhat subjective. The impacts of
these scenarios are measured in relation to the base
simulation for all the endogenous variables- some as
relative deviations and others as changes in level.

The impacts vary over time and across variables, but they
all seem to peak for some variables and trough for others
after 3 years and nearly vanish after 10 years of
demonetization shock. The long-run impacts are thus
nearly zero after 1999-2000. These are illustrated
graphically for some important endogenous variables. The
results for Scenario (d) only are discussed below.

In view of the pivotal role assigned to the reserve money
and money supply in the macro model (Figure-1), any
change in these variables will trigger all round effects in
the macro economy. Also, the two other hypothesised
changes viz. increase in commercial bank deposits and
increase in direct taxes will initiate further impacts
simultaneously. The following immediate effects are likely
to take place.

Due to 5% reduction in reserve money, broad money
supply (M3) will fall by 17.2% propelled by large money
multiplier (4.7). This will cause WPI inflation to fall by
5.9% through a link relationship between wholesale price
index and GDP deflator.




Keynesian money market equilibrium will push-up interest
rate (PLR) by 0.7%. Public sector savings will however
decline by 7.1%; gross domestic savings to GDP will fall by
0.3%.
Despite a 30% counter-factual increase in direct taxes,
due to all other interdependent changes, the net increase
in direct taxes will only be 25%; indirect taxes will
however decline by 4.4%; and govt. revenue will rise by
0.4%.
Nominal govt. consumption will rise by 0.3%; and real
private consumption will fall by 0.4%. Govt. current
expenditure will rise by 0.1% and gross fiscal deficit will
rise by 0.2%.

Exports to GDP and imports to GDP are expected to rise by
0.2% and 0.7% respectively. Indian rupee will appreciate
against US $ marginally by 72 paise. BSE SENSEX will rise
by 18 points; market capitalization will rise by 9.3%.

Overall, due to 5% reduction in reserve money supply
accompanied with rise in deposits and increase in direct
tax collection, together called here as demonetization,
real aggregate demand will increase by 2% and real GDP
in the economy will rise by 0.5%, despite a 5.5% decline in
nominal output. This growth in real GDP is facilitated by
rise in real private investment by 1.3%.

Probably, this is the reason why the central bank in the
recent monetary policy review kept policy rates (Repo and
reverse repo rates) unchanged even after demonetization,
contrary to financial market expectations of interest rate
cut.

Further, to control inflationary pressure due to heavy
inflow of withdrawn currency into commercial bank
deposits, the incremental CRR is fixed at 100% by the
central bank.

After 3 years, all these effects will consolidate and
culminate in a real GDP increase of 2.9% to meet the
12.1% increase in real aggregate demand in the economy.
Nominal GDP will also rise by 0.8%. This is made possible
by a sizable increase in real private investment (24.4%);
increase in public sector savings (3.8%); decline in gross
fiscal deficit to GDP (0.3%); and increase in gross domestic
savings to GDP (3.7%).

As a consequence of rising real income, both rural and
urban poverty (HCR) is expected to decline by 0.3% and
0.1% respectively.

Broad money supply will fall by 2% and thereby inflation
will fall by 3.3%. Interest rate will rise by 0.4%. There will
also be other commensurate fiscal gains. Thus, overall,
recent demonetization will bring significant positive
benefits to the Indian economy in immediate to short-run
time horizon.

It may be mentioned that all the above macroeconomic
effects are perfectly in accordance with well received
economic theory embedded in the estimated macro
econometric model. As already mentioned, in the longrun, these effects will all be nullified (absorbed) into the
economy and other policy measures will be needed to
sustain further growth.
Chart-II: Actual and Base simulation values of
selected macroeconomic variables.
Chart-II Continued -
Chart-III: Impact (%) of alternative policy simulations
(relative to base simulation) on selected macroeconomic
variables.
Chart-III Continued -
Chart-IV: Impact (%) of alternative policy simulations (relative to
base simulation) on selected macroeconomic variables.
Chart-IV Continued -
Immediate impacts of counter-factual Demonetization in India.
Variable/Year
Nominal Income
GDP Deflator
Real Income
Real Private Investment
Public Sector Saving (N)
Gross Fiscal Deficit to GDP (%)
Gross Domestic Saving to GDP (%)
Gross Capital Formation (N)
Real Private Consumption
Govt. Consumption (N)
Govt. Current Expenditure(N)
Govt. Revenue (N)
Direct Taxes (N)
Indirect Taxes (N)
Non-tax Revenue (N)
Money Supply (N)
Interest rate (%) #
Inflation rate (%) #
Exports to GDP (%)
Imports to GDP (%)
Unit Value of Exports
Trade Balance (N) #
Head Count Ratio-Rural (%) #
Head Count Ratio-Urban (%) #
Exchange rate (Rs./$)
Loans (N)
BSE Sensex (2004-'05 = 1.0)
Market Capitalization to GDP (%)
Base
RM↓
Simulatio
n
PS
% Dev
Y
550.61
530.63
-3.63
PGDP
0.40
0.38
-3.67
YR
1384.52 1386.31
0.13
PITOTR
196.95
195.83
-0.57
GDSPUB
-3.07
-4.78
-55.50
GFDGDP
11.86
12.28
0.42
SAVRATE
20.02
19.73
-0.28
GCFADJ
140.80
135.84
-3.52
PVCR
1053.92 1053.54
-0.04
GFCE
66.88
65.39
-2.24
GCE
133.16
131.67
-1.12
TR
99.46
96.26
-3.22
DT
20.94
20.94
0.00
IDT
78.00
75.73
-2.91
NTX
0.52
-0.41
-177.81
M3
244.27
217.56
-10.93
PLR
18.63
19.09
0.46
INFL
0.72
-2.98
-3.70
EXPTGDP
8.05
8.17
0.12
IMPTGDP
13.34
13.76
0.42
UVEXP
0.42
0.40
-3.17
TB
-29.11
-29.67
-0.57
HCRRUR
44.90
44.91
0.01
HCRURB
34.80
34.81
0.00
EXR
23.69
23.87
0.18
LOANS
246.95
254.16
2.92
SENSEX
-0.25
-0.31
-0.06
MKTCAPTGDP
-9.55
-12.71
-3.16
Deposits↑
PS
549.20
0.40
1383.82
196.61
-3.19
11.89
19.93
140.40
1053.65
66.78
133.05
99.24
20.94
77.84
0.46
242.67
18.65
0.52
8.07
13.43
0.42
-29.44
44.91
34.80
22.71
345.69
0.01
4.27
% Dev
-0.26
-0.20
-0.05
-0.17
-3.91
0.03
-0.09
-0.28
-0.03
-0.16
-0.08
-0.23
0.00
-0.20
-12.53
-0.65
0.03
-0.20
0.01
0.09
-0.17
-0.33
0.01
0.00
-0.98
39.98
0.26
13.83
RM↓Deposits↑
RM↓Deposits↑DT↑
PS
% Dev
PS
% Dev
529.16
-3.90
520.44
-5.48
0.38
-3.89
0.37
-5.86
1385.61
0.08
1391.91
0.53
195.46
-0.76
199.44
1.26
-4.90
-59.60
-2.85
7.09
12.32
0.45
12.06
0.20
19.64
-0.38
19.75
-0.27
135.43
-3.81
134.74
-4.30
1053.26 -0.06 1050.12 -0.36
65.28
-2.40
67.08
0.29
131.55
-1.21
133.35
0.14
96.03
-3.45
99.87
0.41
20.94
0.00
26.18
25.03
75.56
-3.12
74.57
-4.39
-0.48 -190.93 -0.88 -268.51
215.88 -11.62 202.33 -17.17
19.12
0.49
19.36
0.73
-3.20
-3.92
-5.18
-5.90
8.18
0.13
8.21
0.15
13.85
0.51
14.06
0.72
0.40
-3.37
0.40
-5.18
-30.02
-0.91
-30.48
-1.37
44.91
0.01
44.98
0.08
34.81
0.00
34.83
0.02
22.89
-0.80
22.97
-0.72
352.93
42.91
356.72
44.45
-0.05
0.20
-0.07
0.17
1.07
10.62
-0.29
9.26
*Rs. ‘000 crores, except for GDP deflator, wholesale price index, rate of inflation, interest rate, unit value of exports, trade balance and head count ratio. N:
Nominal, i.e., in current prices. BS: Base simulation; PS: Policy simulation; #: (PS-BS)100/BS’91–92. Sim-1: Borrowing from commercial banks; Sim-2:
Utilizing net foreign capital inflows; Sim-3: Reducing govt. consumption expenditure; Sim-4: Non-market borrowings.
Short-run (after 3 years) impacts of counter-factual Demonetization in India.
Variable/Year
Nominal Income
GDP Deflator
Real Income
Real Private Investment
Public Sector Saving (N)
Gross Fiscal Deficit to GDP (%)
Gross Domestic Saving to GDP (%)
Gross Capital Formation (N)
Real Private Consumption
Govt. Consumption (N)
Govt. Current Expenditure(N)
Govt. Revenue (N)
Direct Taxes (N)
Indirect Taxes (N)
Non-tax Revenue (N)
Money Supply (N)
Interest rate (%) #
Inflation rate (%) #
Exports to GDP (%)
Imports to GDP (%)
Unit Value of Exports
Trade Balance (N) #
Head Count Ratio-Rural (%) #
Head Count Ratio-Urban (%) #
Exchange rate (Rs./$)
Loans (N)
BSE Sensex (2004-'05 = 1.0)
Market Capitalization to GDP (%)
Base
RM↓
Simulati
on
PS
% Dev
Y
807.79 819.55
1.46
PGDP
0.50
0.50
-0.88
YR
1598.60 1636.48
2.37
PITOTR
267.66 319.71
19.45
GDSPUB
15.24
16.25
6.58
GFDGDP
8.49
8.21
-0.28
SAVRATE
25.44
28.32
2.88
GCFADJ
220.06 247.15
12.31
PVCR
1143.22 1150.50
0.64
GFCE
90.85
91.73
0.97
GCE
173.04 173.92
0.51
TR
150.76 152.64
1.25
DT
31.20
31.20
0.00
IDT
107.05 108.38
1.25
NTX
12.51
13.06
4.38
M3
438.68 439.44
0.17
PLR
15.60
15.90
0.30
INFL
13.06
10.09
-2.98
EXPTGDP
8.59
8.45
-0.14
IMPTGDP
10.06
9.95
-0.11
UVEXP
0.54
0.54
-0.38
TB
-11.88
-12.32
-0.44
HCRRUR
44.01
43.77
-0.23
HCRURB
33.19
33.12
-0.07
EXR
27.94
27.98
0.04
LOANS
234.78 239.47
2.00
SENSEX
0.27
0.25
-0.01
MKTCAPTGDP 17.18
16.42
-0.76
Deposits↑
PS
805.96
0.50
1597.76
267.22
15.09
8.51
25.43
219.49
1142.49
90.71
172.90
150.46
31.20
106.84
12.43
436.62
15.60
13.10
8.61
10.08
0.54
-11.90
44.01
33.19
27.96
234.87
0.26
16.89
% Dev
-0.23
-0.17
-0.05
-0.16
-1.02
0.02
-0.02
-0.26
-0.06
-0.15
-0.08
-0.19
0.00
-0.19
-0.68
-0.47
0.01
0.04
0.02
0.03
-0.06
-0.02
0.01
0.00
0.02
0.04
-0.01
-0.29
RM↓Deposits↑
RM↓Deposits↑DT
↑
PS
% Dev
PS
% Dev
817.69
1.23
814.50
0.83
0.50
-1.06
0.49
-1.94
1635.76 2.32 1644.37 2.86
319.45 19.35 332.92 24.38
16.09
5.54
15.82
3.76
8.24
-0.25
8.24
-0.25
28.32
2.88
29.14
3.70
246.62 12.07 252.05 14.54
1149.78 0.57 1148.84 0.49
91.59
0.82
91.35
0.55
173.78
0.43
173.54
0.29
152.34
1.05
151.83
0.71
31.20
0.00
31.20
0.00
108.17
1.05
107.81
0.71
12.98
3.69
12.83
2.50
437.29 -0.32 429.80 -2.02
15.90
0.31
15.98
0.38
10.12
-2.95
9.74
-3.32
8.47
-0.12
8.51
-0.08
9.98
-0.08
9.98
-0.07
0.54
-0.44
0.54
-0.72
-12.34
-0.46
-12.03
-0.16
43.78
-0.22
43.73
-0.27
33.12
-0.07
33.11
-0.08
28.00
0.06
28.05
0.11
239.58
2.05
240.75
2.54
0.25
-0.02
0.23
-0.04
16.12
-1.05
15.13
-2.04
*Rs. ‘000 crores, except for GDP deflator, wholesale price index, rate of inflation, interest rate, unit value of exports, trade balance and head count ratio.
N: Nominal, i.e., in current prices. BS: Base simulation; PS: Policy simulation; #: (PS-BS)100/BS’91–92. Sim-1: Increasing Real Public Investment by Rs.
5000 crores by borrowing from baning sector in 1991-'92 only; Sim-2: Doubling of debt securities in 1991-'92 only; Sim-3: Doubling of turn over ratio in
1991-'92 only ; Sim-4: Doubling of merger and acquisitions in 1991-'92 only.
Thank You