“Our results imply demonetisation lowered the growth rate of economic activity by at least 2 percentage points in the quarter of demonetisation,” said the working paper entitled ‘Cash and the Economy: Evidence from India’s Demonetisation.’ It compared the move’s effect to a monetary tightening equivalent to about two percentage points.
The paper, which has not been peer reviewed, said that India’s economic activity declined 3 percentage points or more in November and December 2016 even though its effects were dispelled over the next few months.
It also noted some of the possible longer-term benefits of the measure that saw 86% of the currency notes in circulation being withdrawn.
“We conclude that while the cashless limit may appropriately describe economies with well-developed financial markets, in modern India cash continues to serve an essential role in facilitating economic activity,” said the paper authored by Gabriel Chodorow-Reich, Gita Gopinath, both of the department of economics at Harvard University, Prachi Mishra, managing director, global macro research, at Goldman Sachs, Mumbai, and Abhinav Narayanan of the Reserve Bank of India.
Gopinath is set to take over as chief economist of the International Monetary Fund (IMF) next month.
The study, which focused on the short-term consequences, noted that longer-term consequences may include higher tax revenue and a shift to digital modes of payment.
“There may be longer-term advantages from demonetisation that arise from improvements in tax collections and in a shift to savings in financial instruments and non-cash payment mechanisms,” it said, but added that more research was needed.
Citing other studies, the paper compared the magnitude of the peak effect on output of the note ban to a roughly 200 basis point tightening of the monetary policy rate. One basis point is onehundredth of a percentage point.
India’s gross domestic product (GDP) grew 6.8% in the December quarter of 2016, down from 7.6% in the trailing three months. In the subsequent quarter, it declined to 6.1%.
The authors looked for innovative methods of judging economic activity, including satellite images of lights at night, especially in the informal sector.
“The cross-sectional responses cumulate to a contraction in employment and nightlights-based output due to demonetisation of 2 percentage points and of bank credit of 2 percentage points in 2016Q4 relative to their counterfactual paths,” said the paper.
Moreover, it explained that the decline in output will “not obviously materialise in the national GDP data” as national data are volatile and subject to other shocks, making it difficult to discern a single break point around demonetisation.
The study used a “new household survey of employment” and “satellite data on human-generated nightlight activity” besides a number of other datasets to measure the effects of demonetisation at the district level. In the first few months, demonetisation affected essentially all areas of India but with varying intensity, which also depended on how quickly replacement notes reached.
“If trend growth in India was 1.5% per quarter (6% per year), then our estimates imply an absolute decline in economic activity of about 0.5% in 2016 Q4 from the previous quarter,” according to a footnote. “This follows from the 3% decline in November and December and no impact in the pre-demonetisation month of October.”
The authors explained that demonetisation as per their model amounts to a forced conversion of cash into less liquid bank deposits, which in the presence of downward wage rigidity generates a decline in output, employment, and borrowing by firms. Households also switch to noncash forms of payment to attenuate the impact of the cash shortage.