The Indian currency experiment
By Scott Sumner
In 2016, the Indian government demonetized all 500 and 1000 rupee bills. These were worth roughly $7.50 and $15, but are considered large denomination in a low-income country like India. The goal was to reduce corruption, and the experiment was widely seen to have failed.
Here I’d like to focus on another aspect of this natural experiment, the impact on the macroeconomy. Interestingly, India ended up testing a very important tenet of modern macroeconomic theory—the idea that temporary currency injections have very little impact on the economy. A new paper by Amartya Lahiri shows that the reduction in the currency stock and money supply was quite severe, but also temporary:
According to Lahiri, the shock did cause some temporary disruption to the Indian economy, but didn’t seem to impact the growth of GDP over a period of 12 months:
Existing research on estimating the costs of demonetization using disaggregated data suggests that it could have lowered output by as much as 2 percentage points during the demonetization quarter. Almost all work in this area also suggests that the costs were temporary and lasted at most two quarters. This is not a surprise because the monetary shock was temporary and the remonetization of the economy was complete in less than two quarters. Available labor market statistics suggest that up to 3.5 million jobs may have been lost during the three months following demonetization while 15 million people may have exited the labor force.
It is surprising, however, that the aggregate statistics do not reveal much effect of the demonetization shock. Perhaps the most striking is the official aggregate GDP statistic for fiscal year 2016–2017. On January 31, 2019, India’s Central Statistical Organization released a revised GDP series, which estimates real GDP growth in the fiscal year 2016–2017 to have been 8.2 percent, the highest since 2011–2012. This implies that India’s annual GDP growth increased by 20 basis points in the year of demonetization, relative to the previous year. It is possible that growth in the nondemonetization quarters, particularly the period April–September 2016, saw very rapid economic growth that was partially undone by the negative effects of demonetization during the rest of the year. On the face of it, however, the dissonance between the available cost estimates of demonetization from the disaggregated studies and the estimated increase in aggregate GDP growth from the official statistics for that year represents a puzzle which requires a closer examination.
In my view, this was more like a real shock than a monetary shock. Because there was no impact on the medium to longer-term expectations for money growth or NGDP, it had relatively little cyclical effect on the Indian economy. But while there was no major deflationary impact, it did gum up the transactions technology of the India economy. You might almost view it as a technology shock, something like what would happen if all the cash registers or credit card computers had stopped working in America for a few weeks. China’s having a similar real shock right now, as the coronavirus disrupts business for what’s expected to be a few months. Japan had this sort of shock right after the tsunami of 2011. These shocks may impact RGDP for a quarter, but they generally don’t cause the sort of business cycle that creates a lot of unemployment.
When recessions are caused by tight money policies that are expected to persist, as in 2008-09, the effects are much more persistent than a quarter or two. The Great Recession led to almost a decade of elevated unemployment. Real factors determine long run growth, and explain the relative wealth of nations, but monetary factors dominate at cyclical frequencies. Most importantly, the monetary shocks that matter are those that are expected to persist.
PS. At least as far back as Neil Wallace in the 1970s, economists have been looking at the distinction between temporary and permanent monetary injections. In a 1993 paper on Colonial currency, I argued that a temporary currency injection would not be highly inflationary. In 1998, Paul Krugman wrote the definitive paper on liquidity traps, which also hinged on the distinction between temporary and permanent currency injections. Since then, people like Michael Woodford and Gauti Eggertsson have developed formal models where changes in the expected future path of monetary policy are much more important than changes in the current stance of policy.