In the short run, the effect will be a significant decrease in the money supply and a reduction in aggregate demand, ceteris paribus. In the long run, money is neutral: an increase or decrease in its supply will lead to inflation or deflation, respectively, with no change to the real value of anything. But in the short run money is non-neutral, owning to phenomenon such as sticky prices and imperfect information. Therefore a contraction in the money supply reduces growth in the short run, and vice versa. The size and duration depends on how quickly the government can replace the old denominations, which began to lose value after the announcement as businesses did not want accept payments in soon-to-be-worthless money. This led to a seizing up of economic activity, as businesses across supply chains struggle to make acceptable payments to their suppliers. Large lines formed at banks and withdraw limits were put in place.
The mal-effects of monetary contraction will hurt the poor, who rely most heavily on cash, the most. While switching to a bank account is a practical solution for some, fewer than 35% of Indians over 15 use a bank account. Unsurprisingly the poor have the least access to banking and non-cash payment methods.
And it is unlikely the rich hiding wealth from tax authorities hold much of it in cash; more likely it is held in assets such as overseas properties and investments that will be unaffected. By the end of the year nearly all the currency in question had been deposited in a bank and validated as legitimately earned (that or well-laundered). The government replaced many of the old notes with new 500 and 2000 rupee notes; holding illicit wealth in cash will be at least as easy once the transition is complete.
Further out, the increase in bank deposits will lead to an increase in bank lending, thus expanding the money supply and the proportion of economic activity that is within the reach of the tax authorities. Maybe the risky gambit will pay off, my guess is not really. But there are many regulatory impediments to expanding banking to the poor and/or rural residents, which is why so few people use banks in the first place. Reducing such barriers would have the same benefits with less risk.
So far the reaction has been as those economists who believe money is non-neutral in the short run would have predicted. And it is a blow to those economists who rely on mathematical identities (in this case MV=PY [1], which it does in long run equilibrium) over real world observation. The non-neutrality of money means that monetary policy does have the ability to increase or decrease real aggregate demand in the short run, rather than just affect nominal prices. To what degree real economic activity is affected depends on the slope of the aggregate demand curve.
As if to one-up India’s actions, Venezuela’s incompetent president, Nicolás Maduro, announced on December 11th, 2016 that the 100 bolivar note (worth about three cents and falling fast), which accounts for 77% of the country’s cash by value, would become worthless in 72 hours. Businesses refused to accept them almost immediately. The notes are to be replaced with higher denominations (inflation will soon surpass 200%), which weren’t readily available. As of the following weekend, ATMs still spit out worthless 100 bolivar notes. The reason given by the government is somewhat similar to India’s justification: to devalue the illicit wealth held by “mafias” that supposedly hoard bolivars, which the government says is leading to shortages in Venezuela. This is ludicrous. Nobody who has any options would hold their wealth in a currency whose value is plummeting, and if mafias were really hoarding vast amounts of bolivars the effect would be deflationary. The shortages are instead caused by the government’s horrible economic policies, including price controls.
Then on December 18th, after widespread protest, Maduro backed down. Venezuelans were given until January 2nd to exchange their 100 bolivar notes. Then, towards the end of December the deadline was delayed to late January. The fact that the government didn’t have replacement notes ready before announcing the decision played a part in the reversal. But the government can’t un-ring the bell. The 100 bolivar note is still slated to be worthless soon, so its real value, and confidence in the monetary system, will still be reduced. Given the massive monetary expansion in years past (the actual source of inflation) Venezuela needs to reduce the growth of the money supply, which would tame inflation at the cost of short run pain. A less extreme but similar example is the US in the late 1970s, when Fed Chair Paul Volker reduced the rate of money supply growth (which led to higher interest rates in the short run and lower rates in the long run), causing a recession but taming inflation.
The US, Euro Zone, and Singapore, to name a few, have all taken high denominations of cash out of circulation in the past, often citing similar reasons. But there are more or less right ways to do such things, while Venezuela is plumbing the depths of mismanagement.
