ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Monetary Shocks and Market Segmentation

A Short-run Analysis of Demonetisation

This article uses a short-term macroeconomic model in Williamson (2009) featuring goods and financial market segmentation to analyse the effect of such a shock in an economy with substantial informality and cash dependence. The households with access to formal financial markets experience an increase in consumption and those without such access experience a decline.

The author would like to thank Amartya Lahiri, Chetan Ghate, Gurbachan Singh, Jyotirmoy Bhattacharya, and Mausumi Das for their detailed comments and suggestions. Thanks are also due to seminar participants at the Seventh Delhi Macroeconomics Workshop (ISI, Delhi), Delhi School of Economics, Indian Institute of Technology Delhi, and South Asian University, and AUD for valuable comments. Last but not the least, the author greatly appreciates the comments and suggestions by the anonymous reviewer. Needless to say, all errors are that of author’s.
 

A surprise demonetisation, where certain or all denominations of currency notes cease to be legal tender on short notice, can be understood as a severe payment system shock requiring agents to immediately shift to alternative payment mechanisms. This article uses a short-term macroeconomic model in Williamson (2009) featuring goods and financial market segmentation to analyse the effect of such a shock in an economy with substantial informality and cash dependence. The quantitative characterisation of the equilibrium dynamics using a deterministic example shows significant level as well as redistributive effects in the very short run. The households with access to formal financial markets experience an increase in consumption and those without such an access experience a decline. Most of these effects come from differential access to formal financial markets as a consumption smoothing mechanism.

The announcement by the Prime Minister of India on 8 November 2016 that deemed `500 and `1,000 currency denominations as illegal tender is referred to as “demonetisation.” Many developing countries have engaged in such policies where certain or all denominations of currency notes were declared illegal to be used as payments.1 In India, the denominations that were demonetised in 2016 constituted 86% of currency in circulation at that time. This together with the fact that a significant proportion of transactions in India were cash-based, the policy announcement brought the economy to a standstill. People scrambled to their banks to exchange their old currency notes for new ones. They also resorted to using alternative payment mechanisms to pay for their purchases.

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Updated On : 4th Dec, 2022
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