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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