Macroeconomic Transmission of Demonetisation

Demonetisation is the withdrawal of the legal-tender status of specified currency notes. It can affect aggregate demand, the total planned spending on domestically produced goods and services, by changing people's ability to make payments, their incomes and wealth, and the availability of credit. Its effects depend on how quickly usable currency and alternative payment arrangements replace the withdrawn notes.

The immediate cash and consumption channel

The first mechanism is a liquidity shock: households and firms may retain purchasing power in bank accounts but temporarily lack the cash needed for transactions.

• When replacement currency is insufficient and non-cash payments are difficult, households postpone purchases, reducing consumption expenditure.
• Cash-dependent households and businesses are more exposed because they have fewer readily usable payment alternatives.
• Exchanging or depositing withdrawn notes does not itself destroy their owner's wealth; it changes the form in which purchasing power is held.
• If some withdrawn currency cannot be exchanged or deposited, its holders suffer a wealth loss, which can further reduce spending.

Income, investment and multiplier effects

Lower sales can turn an initial payment disruption into a broader reduction in demand through the income multiplier.

• Businesses facing weaker sales may cut production, employment or wages, reducing household incomes and causing further declines in consumption.
• Cash shortages can disrupt working capital payments, including wages and purchases of inputs, weakening firms' operations.
• Lower expected sales and greater uncertainty can lead firms to postpone investment expenditure, adding to the fall in aggregate demand.
• In the simple Keynesian model, an initial fall in autonomous spending produces a larger fall in equilibrium income because one person's expenditure becomes another person's income.
• The size of this amplification depends partly on the marginal propensity to consume and leakages such as saving, taxes and imports.

Banking offsets and the duration of the effect

The contraction need not be permanent. Remonetisation, meaning the restoration of usable currency, and wider access to non-cash payments can ease the transaction constraint.

• Deposits of withdrawn notes can increase banks' deposit funding and potentially support lending or lower lending rates.
• An increase in deposits does not automatically create credit expansion: banks must be willing to lend, and creditworthy borrowers must be willing to borrow.
• Easier credit can support consumption and investment, partly offsetting the initial demand contraction.
• Persistent income losses or weak business expectations can delay recovery even after the immediate cash shortage eases.