Both old monetarists and market monetarists like to describe recessions in terms of a “shortage of money”, caused by either a drop in the money supply or an increase in money demand. In this view, the focus is on money as a medium of exchange.

I’ve always been uncomfortable with that framing, as I don’t think the term ‘shortage’ accurately describes the problem. Rent controls and prices controls on gasoline lead to huge queuing problems. In contrast, there are usually no lines at ATMs, even at the worst points of a recession. Interest rates adjust until money supply equals money demand. In my view, it’s more useful to think of the problem as an increase in the value of money. My focus is on money as a medium of account.

I don’t want to overstate these differences, as we both believe the problem is caused by either a decrease in money supply or and increase in money demand, and we both believe that the effects are higher unemployment, and monopolistically competitive firms having more difficulty finding customers at their current (sticky) prices. (Most firms are monopolistically competitive—having some pricing power, but also facing competition from similar firms.)

I thought of this difference when reading about India’s recent demonetization of 500 and 1000 rupee notes (about $7.50 and $15 in value), which form the bulk of the currency stock in India:

The Reserve Bank of India (RBI), the central bank, has been unable to print money anywhere near fast enough to replace the $207bn in 500- and 1,000-rupee notes that were outlawed overnight on November 8th. Unless India’s four existing money presses can be speeded up, or bills quickly imported, experts reckon it could take five or six months before the money removed from circulation is fully replaced.

According to J.P. Morgan, an investment bank, Indians were making do at the end of November with a little more than a quarter of the cash that had been in circulation at the beginning of the month–and this in a country where cash represented 98% of all transactions by volume and 68% by value. The RBI has in effect been forced to ration new cash, most in the form of 2,000-rupee notes that are, owing to the lack of 1,000s and 500s, exceedingly difficult to break for change.

FWIW, I do not think it will take 5 or 6 months to replace the money (these early official estimates are usually too pessimistic in this sort of situation.). But even if it takes 3 or 4 months, it’s big problem for the Indian economy:

Small wonder that Fitch, a ratings agency, on November 29th cut its forecast for India’s GDP growth for the year to March 2017 from 7.4% to 6.9%. That is in line with most financial institutions’ trimmed estimates, although some economists think the damage could be even worse. “There will be no or negative growth for the next two quarters,” predicts one Delhi economist who prefers anonymity. “Consumer spending was the one thing really driving this economy, and now we are looking at a negative wealth-effect where people feel poorer and spend less.”

In my view, this is the sort of monetary shock that is correctly described as a “shortage” of money. In some ways it’s even worse than an ordinary garden-variety recession. At least Americans were able to get cash in 2009. But in other respects it less severe, as it’s expected to be a temporary monetary shock. It would not surprise me at all if the Indian economy almost immediately returned to full employment after the cash shortage ended. In contrast, employment often takes years to recover from severe monetary shocks that raise the value of the medium of account. (RGDP in India may take a bit longer to recover, for various reasons.)

I think of the Indian crisis as the combination of two shocks, a very mild “medium of account shock” and a very severe “medium of exchange shock”. The medium of account shock is mild because it’s expected to last for just a few months.

So then why did this shock take about 5% off the Indian stock market? Perhaps because there is a tail risk that this will backfire politically, and weaken the Modi government:

Perhaps more embarrassingly for Mr Modi’s government, there are few signs that its harsh economic medicine is achieving the declared goal of flushing out vast hoards of undeclared wealth or “black” money. Officials had predicted that perhaps 20% of the pre-ban cash would not be deposited in banks, for fear of disclosure to the taxman. Yet within three weeks of the “demonetisation”–well before the deadline to dispose of old bills, December 30th–about two-thirds of the money had already found its way into “white” channels. . . .

In another country, such a fiasco would spell disaster for the government in power. Particularly so, one would think, for a party that sailed into office on promises to boost growth, provide jobs and encourage investment. Mr Modi’s opponents have blasted his policy as obtuse, destructive and downright criminal; some insinuate that his Bharatiya Janata Party (BJP) was tipped off about the ban. Opposition parties have held rallies and marches across the country and brought India’s parliament to a standstill with demands for a vote on the ban, and for Mr Modi himself to debate its merits, to no avail so far.

Like the recent Brexit vote, this is a sort of natural experiment, from which we may learn a bit more about business cycles. It will be interesting to watch if and how the current Indian slowdown differs from more conventional tight money recessions. One difference already seems apparent; the action seems to have depreciated the rupee in foreign exchange markets:

The Indian government’s decision to scrap high denomination notes in order to crack down on counterfeiting and money laundering has had the unintentional effect of weakening the Rupee.

On the GBP/INR price chart there is a clear spike on November 9 and 10 after the Indian government surprised markets by announcing out of the blue that it was excluding 500 and 1000 Rupee notes from legal tender.

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Keep in mind, however, that just as we saw after the Trump victory, immediate market reactions can be misleading.

PS. Larry White has an excellent post on this issue, discussing lots of the side effects produced by this policy experiment.