Education > Basics > Understanding demonetization: definition, illustration and mechanics

Understanding Demonetization: Definition, Illustration, and Mechanics

What Is Demonetization?

Demonetization refers to the process of withdrawing the status of legal tender from a currency unit. This typically occurs when there is a change in the national currency, where the current form or forms of money are taken out of circulation and retired. The retired currency is often replaced with new notes or coins, or sometimes, a completely new currency is introduced.

Key Points

When a currency unit loses its status as legal tender, it is referred to as demonetization.
Demonetization can have negative consequences on an economy if not executed properly.
It can be used as a tool to stabilize currency, fight inflation, and promote transparency in economic activities.
India’s demonetization in 2016 is a well-known example.
The term “demonetized” can also refer to digital content that no longer qualifies for revenue distribution.

Understanding the Concept of Demonetization

Demonetization is a significant intervention in an economy that involves withdrawing the legal tender status of a currency unit. Such a move can have both positive and negative impacts, as it affects the medium of exchange used in all economic transactions. Countries undertake demonetization for various reasons, such as to stabilize their currency or combat inflation.

One famous example of demonetization was the Indian government’s decision in 2016 to withdraw 86% of the country’s currency from circulation. The move aimed to curb corruption and illegal activities, but it resulted in significant economic disruption, especially for the poor and those in the informal sector.

Demonetization has been used historically to stabilize the value of a currency, as was the case with the Coinage Act of 1873 in the United States, which demonetized silver in favor of the gold standard. However, this move led to a contraction of the money supply, contributing to a recession. As a result, the Bland-Allison Act was passed in 1878, which remonetized silver as legal tender.

In 2015, the Zimbabwean government turned to demonetization as a means of addressing its severe hyperinflation problem. With staggering month-over-month growth of 79.6 million percent and year-over-year growth of 89.7 sextillion percent, the country’s economy was in dire straits. The three-month-long demonetization process involved phasing out the Zimbabwean dollar from circulation and adopting the U.S. dollar, Botswana pula, and South African rand as the country’s legal tender in an effort to stabilize the economy.

Demonetization has also been used to promote trade and currency unions among nations. For instance, when the European Union introduced the physical euro bills and coins in 2002, member nations such as Germany, France, and Italy demonetized their former national currencies and adopted the euro. Although the old currencies were still convertible into euros at fixed exchange rates for some time to ensure a smooth transition, the demonetization paved the way for the euro to become the common currency of the European Union.

Advantages and Disadvantages of Demonetization

Demonetization has its advantages and disadvantages. One of the advantages is that it can help reduce fraudulent financial practices, as individuals will be unable to exchange illegal tender with banks. This can also help reduce tax evasion, contributing additional revenue to a nation’s economy. Additionally, demonetizing physical paper tender can showcase an advancing banking system by making digital currency more accessible, safer to store, and easier to transfer ownership. Organized industries and companies often benefit the most from demonetization, as it results in an easier transition for them.

However, demonetization can also have its drawbacks. It can be inconvenient for citizens, and the phased-out process of only select denominations may cause confusion. As a result of the disturbance, a nation’s economy may temporarily experience stalled growth during the demonetization process. Additionally, there are costly logistical measures to be taken, such as modifying and recoding ATMs and other means of disbursing cash. Consumer prices must also be reframed to ensure proper change can be given if needed. Daily wage earners, who are often among the poorest with little to no savings, may be paid in defunct tender and must miss work to exchange their earnings with a bank.

Demonetization

Pros of Demonetization:

Decreased tax evasion and increased tax revenue due to greater transparency and accountability
Potential for higher long-term GDP growth as increased tax revenue can be reinvested in the economy
Encourages innovation by promoting the use of digital currency and digital transactions

Reduces overall crime by making it more difficult to circulate illegal money

Cons of Demonetization:

Imposes a burden on citizens, especially those who need to convert currency.
Leads to a short-term slowdown of GDP during the conversion process.
Incurs high administrative costs, including printing new currency, adjusting ATMs, and marketing changes.
Can negatively impact cash-driven sectors, potentially causing them to halt.
Introduces new types of currency risks such as cybercrime.

Example of Demonization in India

In 2016, the Indian government used demonetization as a tool to modernize a cash-dependent developing economy and combat corruption and crime such as counterfeiting and tax evasion. The two biggest denominations in India’s currency system, the 500- and 1000- rupee notes, were demonetized, which accounted for 86% of the country’s circulating cash. Prime Minister Narendra Modi announced the decision with little warning on November 8, 2016, stating that those notes were immediately worthless, and citizens had until the end of the year to deposit or exchange them for newly introduced 2000 rupee and 500 rupee bills.

In 2016, the Indian government implemented demonetization as a means to modernize the cash-dependent economy, combat corruption, and reduce crime. This move involved the discontinuation of the 500- and 1000- rupee notes, which made up 86% of India’s circulating cash.

Chaos ensued as citizens were given little warning and had until the end of the year to deposit or exchange their old notes for newly introduced 2000 rupee and 500 rupee bills. Long lines formed outside ATMs and banks, which had to shut down for a day. Only 60% of the country’s 200,000 ATMs were operational due to the different specifications of the new notes, and even those dispensing bills of lower denominations faced shortages. The government’s restrictions on daily withdrawal amounts exacerbated the situation, and severe cash shortages continued through 2018.

The implementation of demonetization adversely affected small businesses and households, causing them to struggle to find cash. Reports surfaced of daily wage workers not receiving their dues, and the rupee fell sharply against the dollar.

The government’s goal was to eliminate counterfeit currency, fight tax evasion, eliminate black money gained from money laundering and terrorist financing activities, and promote a cashless economy. Individuals and entities with large sums of black money were forced to take their old notes to the bank and provide tax information. Failure to do so incurred a penalty of 200% of the owed amount.

Other Uses of Demonetization

Refers to the business practice of denying payment, often related to social media.

Happens when a platform’s content creator used to receive payment but is no longer eligible due to underlying changes in the platform.
Similar to discontinuing legal tender in that an asset once held value but no longer holds any monetary value.

Why Would a Country Demonetize?

To stabilize the value of a currency or combat inflation.
To facilitate trade or form currency unions.
As a tool to modernize a cash-dependent developing economy and combat corruption and crime (counterfeiting, tax evasion).

Advantages of Demonetization

Demonetization offers several benefits, including curbing criminal activities by removing illegal tender from circulation. This includes preventing the circulation of counterfeit currency, as counterfeiters cannot exchange their fake notes without being detected. Additionally, it can help combat tax evasion, as individuals with undeclared income must declare their currency and may be taxed retroactively. Finally, it can promote the shift to digital currencies by slowing down the circulation of physical currency.

Disadvantages of Demonetization

Despite the benefits, demonetization also has several drawbacks. One of the main concerns is the high cost of printing and minting new currency. Additionally, the effectiveness of demonetization in reducing criminal activities is not always guaranteed, as individuals may hold assets in other forms beyond physical currency. Finally, this process can be risky, and if not handled with care, it can lead to chaos in the economy.

How Does Demonetization Affect GDP?

Initially, demonetization typically hinders economic growth and leads to a decline in GDP. As the conversion process takes place, many industries and sectors may be temporarily disrupted, leading to potential difficulties in paying laborers.

However, in the long run, demonetization often leads to economic benefits that can increase GDP. By targeting financial crime, demonetization can make transactions more transparent and discourage the circulation of illegal currency. As a result, governments can collect more tax revenue and make greater investments in their country, leading to long-term growth in GDP.