The Economics of India’s Rs. 2,000 Note
June 2, 2023
By Romar Correa*
A ditty in economics textbooks of my time was “Money is a matter of functions four; a medium, a measure, a standard, and a store”. Abstruse debates about the inclusion or relative importance of one or the other are still conducted by fastidious scholars but at any rate a subset of the characteristics is regarded as fundamental to the notion of money. Let us take each in turn.
The “medium of exchange” function pertains to the acceptance of cash on the barrel in markets. A ‘measure’, as the term suggests, is inviolability like metres, or kilograms, in calculations. What is the measure of a Rs 2,000 currency note on September 30, 2023? The correct answer is not zero because the horizon might be moved out. There is also the proclamation of unfathomable mystery that the note would continue to be legal tender.
What is the measure of Rs 2,000 today? Precipitously less than it was before the announcement of its demise last month, of course. Indeed, it would be perfectly rational for buyers and sellers to drop it from their dealings immediately.
We are reminded of the core of mainstream macroeconomics, “rational expectations”, in the recent demise of economist Robert Lucas. A corollary is that governments cannot fool all the people all the time. Twice bitten …. Rumours are circulating that a Rs 1,000 note is to be introduced by India’s central bank, the Reserve Bank of India (RBI). It will be regarded with suspicion because the credibility and reputation of the RBI in using its privilege of monopoly of note issue cannot be higher than that of any other country.
The ‘standard’ concerns the “unit of account” attribute of money. The rupee is the foundation on which nominal calculations are made. It is the basis of pay hikes and the setting of profit margins. Finally, the “store of value” function of money is faith in the monetary authorities/government. Economists assume that people will always hold money despite the higher returns offered by near-liquid alternatives like mutual funds because the zero return and zero risk attached to rupees might dominate the high returns and high risks of holding financial instruments. Wall Street melted in 2008 and 2022 but the dollar endured.
The divisibility of units of money is not a subject in monetary economics except in economies with unusually-high denomination notes which can only be used by the wealthy and for nefarious activities. Thus, imagine the existence of a Rs 20,000 note. As with black money in India, the rich invest in real estate and financial assets. India is reportedly at the forefront of innovations in whitewashing black money through election bonds and round-tripping via Mauritius of funds held by family and friends abroad. Thereby, a Midas can appear from the shadows and touch every private and public part of an economy. Therefore, demonetisation of high-denomination notes has a rationale when the intent is to curb drug smuggling and terrorism and the like.
There is a more serious implication of the perfect substitutability of lower-denomination paper. Since notes are changeable along a line forged by trust, the breaking off of links randomly cannot but weaken the chain. It is not just the Rs 2000 note that will not be an “abode of purchasing power” anymore but that money will lose its value.
Some of the principles can be illustrated by simple numerical examples. The real value of anything is the rupee value deflated by a price index. If the price level is 2, the real value of a Rs 2,000 note is 2000/2 = 1000. If the price level doubles to 4 (inflation), the real value of the paper drops to 2000/4 = 500. In hyperinflationary regimes, the denominator or the inflation rate gallops and the real value of a Rs 2,000 note does not survive the day.
The case for demonetisation of the currency here is the unusually-high increase in the value of the denominator and has informed demonetisations in history. The action of the Indian government in 2016 was pioneering in going for the numerator independent of the denominator. The numerator can only be hit by shocks. For example, imagine the market value of a conglomerate running through all sectors of an economy when the investment plans are found to be not backed by rigorous production schedules but debt for the purpose of retiring earlier debt. Once the Ponzi scheme is exposed, zeroes are lopped off the trillions in the numerator. In addition, once more we are reminded that modern India is not less generative of new, if inexplicable, ideas than Ancient India. The Rs 2,000 note, reportedly, was introduced on a timetable. It has fulfilled its destiny and must now be consigned to the shredder.
The meaninglessness of the episodes of demonetisation in India is easily demonstrated. The lower middle class, petty traders, and so on transact in cash. Most of my daily purchases require cash. Consider a random visit to the bank for the purpose. I request a bundle of Rs 500 or Rs 100 notes. The bank might have run out of them. I am handed a couple of Rs 2,000 notes, apologetically. A pall is cast on my shopping day. The smile of my grocer gives way to a frown. No more. Rs 2,000 equals Rs 500 multiplied by 4. The value of my expenditures is unchanged. Flipping the example back in time, a stack of four Rs 500 notes demanded by me at the cash counter in October would be substituted by one Rs 2,000 note after November 2016. Nothing of note changes!
Rs 2,000 notes is a stock. Rs 100 notes is a stock. They are held by banks or people. That is the definition of money. A related concept is the velocity of circulation of money or the frequency with which a note changes hands. Undoubtedly, the Rs 500 note would circulate more frequently than the Rs 2,000 note but what matters is the average for the economy. Along with the quantity of goods and services that are bought and sold with the stock of money, the price level is determined in what is called the Quantity Theory of Money. Thus, with money 2,000, a velocity of circulation 3, output or real GDP 3000, the price level is 2. That is, 2000x3 = 2x3000. Drumming home the point made earlier, nothing changes if I substitute 100x20 for 2,000.
Even when legal tender, acceptance of cash is a matter of convention. Over time, low-denomination coins or high-denomination notes may cease to be accepted in payments and aggrieved parties do not take recourse to the law despite fiat money meaning the fiat of government. It is likely that the Rs 2,000 note would have died a natural death. There might have been announcements of the withdrawal from circulation of 10p, 25p, 50p coins but did anybody pay attention? Why, then, the fanfare in this case? Have we sounded the death knell for the Indian rupee?
* Romar Correa retired as the Reserve Bank of India professor of economics at Bombay University.
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