Macroeconomic Effects of Demonetization in India: Policy Simulations using a Macro Econometric Model for India

24th December, 2016 – By Dr. Prof. KN Murty

On 8th November 2016, Prime Minister Sri Narendra Modi 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 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 his study was 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 one-period increase in bank deposits and one-period increase in direct tax collections were undertaken. He used the ‘ narrow ’ or reserve money aggregate for this purpose.

The seminar, presented as an exercise, was therefore an attempt to understand this complex monetary-fiscal scenario and make some scientific guesses about macroeconomic impacts of ‘ Demonetization ’ in India.