What is demonetization? Demonetization occurs when a particular type of currency is withdrawn from circulation. In such a situation, the demonetized currency ceases to be recognized as a legal tender.
Demonetization means stopping a form of currency from being legal tender. That means that this currency can no longer be legally used. It cannot be used to buy things and if it is paid into the bank, your bank manager should not accept it.
Demonetization can be applied to coins, bank notes and all other forms of currency. After a certain cut off date, it is not possible to use those notes and coins to pay for things. Usually, demonetization is part of a wider process, which involves the old currency being replaced by a new one.
An explicit policy of demonetization makes the whole process clear: the old banknotes will no longer be considered legal tender.
Advantages of demonetization
Demonetization was introduced as a policy because it was thought to have numerous advantages. Below are some of the key advantages that are often associated with demonetization.
- Getting fake currency out of circulation: Demonetization can also be used to get fake currency out of circulation in a country’s economy since such currencies cannot be deposited in banks and other financial institutions.
- Controlling inflation: Demonetization is usually cited as having one key advantage: this is that it can control inflation. Taking certain notes out of circulation can help the government to control public spending.
- Tax Collection: Money deposited in the bank during demonetization can be taxed especially if the affected parties were trying to evade taxation by keeping hard cash.
- The move to digital currency: Some commentators argue that in the future, we will all be using digital currency, such as bitcoins. If this is true, then one advantage of demonetization is that it will help to propel us into the future.
- Improved deposits and savings in financial institutions: Parallel economies make it difficult for banks and other financial institutions to raise deposits. Demonetization reduces the size of the parallel economy and boosts savings and deposits.
- Stopping fraudsters: When a new currency is introduced, this can also be a great opportunity to halt the activities of fraudsters who had been making money illegally by counterfeiting coins and notes.
- Reducing illegal activities: Money used to fund illegal activities such as terrorism and drug trafficking will be rendered useless. Hence, the government can use demonetization policy to trace money that has been made from illegal activities such as drug trafficking and theft since such individuals are faced with only two options: either deposit the money with the bank or be left with currency that has no value.
- Growth in a country’s GDP: Due to low lending rates, improved revenue collection, and growth in savings and deposits, a country that has demonetized is likely to see an improvement in the growth of its GDP.
- Introducing new bank note designs: Demonetization is also a good opportunity to redesign bank notes. This might involve making them more durable, for example. Several countries have switched from paper notes (which tore or got worn very quickly) to more durable plastic notes, which has made their monetary system more secure in several ways.
- A measure of good governance practices: Some experts claim that demonetization policies improve the ease of doing business and is also a measure of good governance.
- Good income management habits: People will opt to invest their money in properties such as real estate or deposit cash in banks to safeguard against some negative effects of demonetization.
- Reduction of lending rates: Availability of cheap deposits in financial institutions means that people can borrow money at low interest rates.
Disadvantages of demonetization
Demonetization is not all beneficial and even proponents of demonetization acknowledge that it does have its disadvantages. A few of them are outlined below.
- Little cash in circulation: Cash crunch is a major disadvantage of demonetization due to the unavailability of small currency denominations, an issue which makes it difficult to make small purchases.
- Inconvenience and annoyance to the public: Sometimes, demonetization can be very inconvenient. For example, sometimes the government will remove certain denominations of bank notes from circulation but keep others. It can be annoying when smaller coins are removed from circulation and you do not have enough change. Further, queuing up in banks to deposit money or exchange currency can be inconveniencing.
- Slowdown in Economic Growth: Economic growth will experience a period of lull due to business disruptions, at least in the short term.
- Panic: Not everyone understands the essence of demonetization and, therefore, such an exercise is likely to result in panic among a section of the population.
- An avenue for fraud and corruption: Some people are likely to take advantage of lapses in the financial system to engage in fraud and corruption when exchanging currencies.
- Disruption of Trade: The normal trading activities may be disrupted by this process since it takes time for consumers and suppliers to adjust to the new monetary policy.
- Loss of tradition: People can feel attached to their old bank notes and coins as they can feel that they constituted part of their tradition.
- Problems with paying bills: If someone has sent some bank notes in the post in order to pay a bill, or if there is any substantial delay in processing a bill payment, and demonetization hits in the mean time, the money set aside to pay the bill can become invalid. This is more common that you might think in highly bureaucratic systems.
- ATMs have to be re-calibrated: ATM machines have to be re-calibrated to accommodate the new currencies. It will result in additional costs for banks and also inconvenience customers.
- Short term financial crisis for poor people: If people adopt a new currency and this currency is not a successful one, then it can cause a financial crisis for everyone who is involved. Even a small change in the value of everyday items, or even a small amount of confusion about whether a currency is valid can mean a lot of hardship. As such, demonetization can increase and exacerbate inequalities within society, at-least in the short term.
- Confusing: Demonetization can be confusing and annoying – especially for people who are not able to get rid of their old notes in time.
Demonetization is a beneficial process even though it has some demerits that may render it unfavorable in various ways. However, before any demonetization program is carried out, it should be carefully though through and its impact on the poor should be considered. In this way, demonetization can be a chance for a fresh new start, or it can be something that causes unnecessary confusion for a country.
Contributors: (1) Victor, (2) Laura.