dmpq-. Discuss how Demonitsation effected money supply (M3) and Reserve Money (Mo). Also explain why currency in circulation in a liability for Government.

. When a currency note of a particular denomination ceases to be legal tender, the central bank’s liabilities are reduced to that extent and also the amount of currency in circulation declines.

On November 8, 2016 Government of India made Rs. 500 and Rs. 1000 notes invalid. This meant that Rs. 15.41 lakh crore worth of high-value legal tender was withdrawn from circulation.  So, the entire liability of Rs. 15.41 lakh crore due to Rs.500 and Rs.1000 notes in circulation was nullified.  But the demonetisation impact is neutralised when the demonetised currency is replaced with new accepted currency notes. You may note that, even if an individual chooses to park the cash as deposits with banks, it forms a part of the overall money supply.

This figure (Rs. 10000 crore) was only a nominal reduction in liability, offset by printing and transportation cost of the new currency, which led many experts to point out that the demonetisation experiment was a failure to curb black money. Many criticised the government that it over-estimated the black money in the country.

Section 26 of the Reserve bank of India Act 1934 (“RBI Act”) states as follows: (1) Subject to the provisions of sub-section (2), every banknote shall be legal tender at any place in India in payment or on account for the amount expressed therein and shall be guaranteed by the Central Government.  This means that the money the public hold in hand or in the bank is a debt guaranteed by the government (to us). The currency thus represents a ‘public debt’ owed by the government to the holders of the banknotes – the public.

 

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