Demonetization refers to an economic policy where a certain currency unit ceases to be recognized or used as a form of legal tender. In other words, a currency unit still loses its legal tender status as a new one comes into circulation.
The government can take such decisions to stop the circulation of a denomination of notes or coins in the economy.
The currency unit that has been demonetized is withdrawn from circulation. During the implementation of this policy, the currency unit that has lost its status as a legal tender is deposited with the banks or other authorized financial institutions and replaced with units that still have legal tender status.
The government from time to time formulates fiscal policies that are meant to spur economic growth. A lot of black money circulates in the economy, and most of it is unaccounted for because the sources of income are not known to the government. It can be money generated through illegal trade or unauthorized funding. To mop up this money out of circulation, the government can demonetize so that the money holders are forced to deposit the cash with the banks or lose their wealth. It is a strategy that has worked quite well for some countries.
Demonetization can also be referred to as the process of moving people from a cash-based system to a cashless system (digital system).
Keeping hard cash is a practice that is not encouraged by the government as well as financial institutions. It is easy for people to evade taxes in an economy where people mostly deal with cash. Keeping cash out of the bank also erodes the deposit base of these financial institutions and drives the cost of credits through the roof. It means that the government has to opt for foreign sources to secure funding and in the process increase the national debt. The economic impacts of which are many and severe. Moving people to a cashless system is, therefore, a favorable economic policy for many stakeholders.
To demonetize in its simplest definition is thus to do away with cash. In a market environment that is mainly defined by technology and efficiency, it is every government’s desire to have a huge section of the population embracing electronic and mobile payment methods.
There are several economic as well as social impacts of demonetization. It can reduce inflation, improve the economy, and result in financial behavior change among citizens. However, if not managed well, it may cause a lot of economic hardships to the people. How the process is managed immensely determines its effects on the economy of a country.