As the country says goodbye to the old 500 and 1,000 rupee notes, and with restrictions on exchanging money and taxation on high amounts of deposits, Indian economy is going through some serious churn. But how is this going to affect the economy in the short run as well as the long run?
Cash crunch
The 500 and 1,000 rupee notes were the largest denomination of money, which made up for 14 lakh crores in circulation. Demonetization has a direct impact on sectors dealing with cash—vendors, auto rickshawwallahs, taxi drivers, daily wage earners and small traders. The Indian system mainly functions on cash, and so, less cash means disruption in the flow. Even sectors like real estate, which deal with illegal cash transactions, will go through a rough patch leading to fall in profits.
Interest rates
When money is deposited in the bank, one earns interest for the same. After the announcement of note ban, there have been huge cash deposits in banks. In fact, some of the leading public and private banks have reduced the interest rates on deposits. Depositors might get lesser interest on their deposits, but the good news is that it will have a long-term positive effect on the economy as the lending rate (interest rate on loan) will fall. This will boost credit and investment, to recover the slumping economy.
Inflation
Total cash available, and by this we mean the supply of money, has fallen, which may lead to deflationary pressures (general price level becomes lower). In effect, it implies less cash compared to the supply of goods. But as the price levels in India have been high due to high inflation, fall in money supply can actually help in bringing down inflation. With unaccounted money being wiped out, we can expect lesser pressure on demand. Fall in inflation will help the common man, because goods will now become cheaper.
On the other hand, due to the slowing economy, if production falls more than the fall in the supply of money, then the demand for goods will overshoot the supply of goods, which in turn will lead to higher inflation. It all depends upon the effect on production and economic activity in the nation.
The tax effect
Deposits above Rs 2.5 lakh that have not been justified or declared to the income tax department will be penalised and taxed 200 per cent. This can help bring black money into the white money fold, making it legal. This can also provide revenues for government, which can be used to pay the deficit in the budget estimation. If economic activity is slow, then the indirect taxes (tax on goods and services) will be lesser than estimation. It all comes down to which is more, collection of penalties and taxes, or the fall in indirect taxes. Demonetization could be the first step in creating a ripple in the taxation policy before the Goods and Service tax (GST) rolls out.
Growth
The gross domestic product, which is a parameter to measure growth in the economy, will take a hit. Research firms have already cut growth estimates by 0.5 per cent. India’s economy could shrink as there are many sectors run by cash. There are a lot of businesses in the non tax-paying sector, which will now be formalised; they will have to give up their market share to the organised sector. This will cause shrinking of the economy and a fall in the growth.
On the other hand, though there may be a fall in consumption due to shortage of cash, growth won’t take a hit as high demand and consumption during the recent festival time would offset the effect of fall in consumption and compensate for the fall.
This process would also forcibly bring in huge amount of money from the informal sector, which was unaccounted for. This will help in the growth and therefore GDP would not face a negative impact.
