Prime Minister Narendra Modi's demonetisation move will have an impact on India's gross domestic product (GDP) and inflation as well. Having said that, how much this shock move of demonetising Rs 500 and Rs 1,000 currency notes will hit Asia’s third largest economy in short and long run is debatable. At present, we are at a comfortable cushion of 7.6 per cent GDP and are most likely to sustain that in future according to the experts.
The recent announcement which restricted the supply of money and ability to transact will lead to low economic activity in round one, and through multiplier effect will impact subsequent rounds and have bigger implications, says Shruti Tripathi, Senior Economist, National Institute of Public Finance and Policy.
The cash based economy as India is, Tripathi says we would definitely feel the crunch. In the short-term, GDP growth may get impacted negatively using the quantity theory of money. “If total amount of money in circulation in an economy goes down keeping velocity constant, the nominal (money) value of output will go down.”
Anushka Sawarkar, Economist, CARE Ratings, is of an opinion that the GDP formation could be impacted by this measure, with reduction in the consumption demand, however this fall is likely to be offset with the recent rise in festival demand, “This expected impact on GDP may not be significant as some of this demand will only be deferred and re-enter the stream once the cash situation becomes normal”, said Sawarkar.
What brings in the good news is that the long term impact of the same is expected to be positive, given a condition. In the longer run, the extent of its impact on growth will depend on the size of unaccounted money in the economy,
The World Bank report of 2010 estimated the size of India’s shadow economy at 22.4 per cent of GDP (average for 1999 to 2007).
“If we assume that this situation continues to persist, then a quarter of GDP which earlier was outside the formal economy will get into the economy and will have positive impact.”, said Tripathi.
Finance minister Arun Jaitley, in the press conference on Wednesday, ruled out any short-term impact of demonetisation on growth, which according to him would rather benefit growth in the long run because “all this will impact the size of the GDP itself because more transaction that were happening outside the (formal) economy will get into the economy itself”.
The biggest sufferers would be unorganised and informal sector as they predominantly deal with cash. Other loser would be mid- and small- cap companies which collect and make payments in cash. This pain will continue till this stock of cash is replenished by the banking system, which can be a quarter or two. “The consumption spending will go down in the rural economy owing to the penetration of financial services in the rural area.”
Elaborating on capital flight fear, Sawarkar says the impact is expected to be limited with strong restrictions and regulations, making it difficult to convert all of the same by purchase of gold or foreign currency.
On inflation, the price level is expected to be lowered due to moderation from the demand side, according to CARE Ratings research paper. Tripathi says that lower money supply would lead to deflationary pressure with too little money chasing too many goods. However, on the contrary, some economists believe that the move might work the other way round and help curb inflation with lower money supply as unaccounted money would be taken out of the system.
In spite of the initial hiccups and disruptions in the system, eventually this change will be assimilated in the system and is to eventually prove positive for the economy in the long run. This move by the government along with the implementation of the GST will eventually make the system more accountable and efficient.
BW Reporters
Naina Sood is a Economics graduate and has done her post graduation in International economics and Trade. She has deep interests in Indian economy and reforms
