India’s Rs 500 And 1,000 Demonetization Is Lowering Interest Rates And Also Inflation

An interesting side effect here of India’s demonetization plan. As we know, the Rs 500 and Rs 1,000 notes have been cancelled as legal tender, to be replaced by other notes and designs. There are limits on how much cash can be changed for cash (Rs 4,000, soon to fall to 2,000) but no limits upon what can be deposited in bank accounts. Of course, large deposits are going to be subject to tax scrutiny, rather the point of the exercise in fact. But what is interesting is that the flood of cash being deposited is such that it’s actually bringing interest rates down. This is an interesting and welcome macroeconomic effect:

State Bank of India (SBI) reduced rates on deposits from one year to 455 days to 6.90%, down 15 basis points, while keeping the 7% rate for deposits between 211 days to one year unchanged. That may not be great news for those putting their money in banks but lending rates are likely to follow suit in a few weeks, possibly giving sluggish credit expansion a much-needed boost and shoring up growth. A basis point is 0.01
percentage point.

“All rates will fall,” said SBI Chairman Arundhati Bhattacharya. “The bank has seen huge inflow of deposits but demand for credit has slowed down. Therefore, lending rates too will fall but after a gap.”

Agreed, that’s not a large drop but it all helps. Lower interest rates should, all else being equal, produce a stimulus to the economy.

There’s also another interesting effect here, the money supply will be smaller as well. That of course is contraction960x0.jpg, just as that interest rate change is expansionary. But India does have inflation and as Milton Friedman told us, inflation is always and everywhere a monetary phenomenon:

Of the Rs 14 lakh crore worth of Rs 500 and Rs 1,000 notes that have been scrapped, roughly Rs 3 lakh crore are not likely to be exchanged for new notes ever. This entire extinguished or disappeared black money will be profit to the RBI, and will be transferred to the central government as dividend.

That does of course depend upon that estimation being correct. One lakh crore is, to those of us using the western notation system, one trillion, thus the current estimation is that 3 trillion rupees will be withdrawn from circulation. The total cash in circulation in the Indian economy is some 18 trillion Rs, meaning that the demonetization will reduce that money supply, the base money supply, by 16 or 17 % or so. Dependent upon that estimate being correct of course.

We don’t have a big enough evidence base–not enough places have done this often enough–for us to know how much this will reduce inflation by but we are sure of the sign of this action itself. Reducing the base money supply will lower inflation. Of course, it’s possible that the shock to the economy will lead to a reduction in production and the total effect will depend upon the interaction. If the destabilization reduces production by more than that fall in the money supply then we’ll have more, not less, inflation. But it would be extraordinary to believe that production is going to fall that much.

And, of course, there’s the taxation effect:

Any deposit that is significantly in excess of Rs 2.5 lakh and reflects an “abnormal” rise in income is likely to be scrutinized and subjected to a 200% penalty+ as it may not be seen as eligible for the current year’s tax assessment, tax authorities have said.

A sharp increase in income that does not seem consistent with past patterns will need an explanation though smaller increases in deposits might be acceptable as part of the ongoing 2016-17 tax assessment. Penalties can be challenged but scrutiny of large cash deposits will be on the cards over the next few weeks.

Which gives us our third macroeconomic effect. At least some of that money will indeed be taxed and it would not have been taxed without the demonetization program. This means that the budget deficit will be smaller that it otherwise would have been. This will have knock on effects upon interest rates and inflation once again.

All in all then a rather interesting set of effects. A lower budget deficit, lower interest rates and also lower inflation. Not bad for the one simple plan, is it?

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s