Today Narendra Modi, the Prime Minister of India made a surprise announcement to scrap Rs. 500 and 1000 notes- by Nov 8 midnight these notes will cease to be a legal tender. Indian citizens will get couple of months to exchange these notes for the denominations that are still legal tender. The government will introduce new Rs. 500 and Rs. 2000 notes later. According to media reports, the aim of this move is to reduce black money in the economy, tackle potential fake currency allegedly being circulated by Pakistan and curb corruption. The question of course is would such a move be helpful in achieving these objectives.
Would such scrapping reduce the total currency in circulation? It most likely will as people find it hard to convert all their currency hoards in time for denominations that are legal tenders. This one time reduction in money in circulation could help control for inflation and possibly redistribute resources away from the commodities and services bought by such cash. However, this effect might only be temporary. The new Rs. 500 and Rs. 2000 notes will become the new store of value for people who have a need to hoard and transport large amount of cash. The time period between abolition of current high denomination notes and introduction of new ones will be the time when hoarding black money would be difficult. But ultimately, if the government thinks that black money is a function of availability of high denomination currency notes then not much will change in the long run. To make sure hoarding and transportation of cash is difficult on a more long term basis, it might be advisable to reduce high denomination notes permanently and possibly have it done simultaneously by other countries as argued in this recent article from the Economist.
To address the problems of black money and corruption on a more permanent basis, we will have to look at root causes of these phenomenon. Not all black money is illegal- the monthly cash transaction between you and your maid is also a part of the black economy. Every time you decide not to insist on a receipt for your transaction, you are participating in the black economy. Hundreds and thousands of Indians participate in these transactions on a daily basis contributing to the black economy. So behavior of common people is a part of the problem and solution. There is also an element of redistribution in corruption. If there is lack of equal opportunity and/or presence of persistent inequality, corruption might serve as a way of redistributing money from the haves to the have nots. Sometimes black economy might be a reaction to excessive state regulation and corruption. There is a rich literature that looks at the causes and consequences of shadow or informal or black economies. See Schneider and Enste (2000), a comprehensive survey published in the Journal of Economic Literature.
Therefore to seek a long term solution to problems of black money and corruption we might have to dig deeper than just surprise scrapping of higher denomination notes.
Update: Read my critique of the Arthakranti proposals here. Looks like some of the ‘wisdom’ behind Modi’s move came from that!