What is Demonetization?
The economic process of demonetization results in the currency unit of a nation losing its legal tender status. In the case of demonetization, we often refer to real money, such as banknotes and coins, as a currency unit. When a government demonetizes its currency, it effectively loses its value because it can no longer buy goods and services.
Demonetisation, including changes in the country’s currency or the phase-out of obsolete payment methods, can happen for several reasons. Numerous nations have used currency demonetization methods with varying degrees of effectiveness.
The Process of Demonetization
Demonetization is a type of economic intervention in which a nation switches from one type of money to another. The old currency is withdrawn from circulation at the start of the demonetization process and replaced with new forms of money.
Before the old currency is formally phased out, individuals are given time to swap their old banknotes and coins for new ones. A currency that has been discontinued is no longer recognized as legal tender and has no intrinsic value.
A nation may install new coins or banknotes as part of the demonetization process or switch over entirely to a new type of money. Demonetization is an extreme step that rarely happens and, if done incorrectly, can lead to social unrest. Remonetisation is a procedure that occasionally sees nations decide to reintroduce abandoned currency as legal tender.
Motives for Demonetizing
Countries all across the world have used demonetization procedures for a variety of reasons, even though it is uncommon. Some such reasons include the following:
- If the currency’s value spirals out of control due to hyperinflation, governments may implement demonetization.
- Demonetization can also stop illegal activity, including tax evasion, terrorism, and counterfeiting.
- Demonetization may happen in various situations to introduce a new monetary system. For instance, the European Union created the euro in 2002 as a major currency to replace the currencies of various countries. By adopting the euro as the standard across the European Union, European nations abandoned their native currencies.
A more recent example is the demonetization of the dollar by the Zimbabwean government in 2015 to battle hyperinflation in its nation. Zimbabwe’s hyperinflation peaked at a 79.6 million percent increase monthly and 89.7 sextillion percent growth year over year.
To stabilize the economy, a three-month process involved removing the Zimbabwean dollar from the nation’s financial system and establishing the US dollar, Botswana pula, and South African rand as the nation’s legal tender.
A nation can benefit from currency demonetization in many ways, such as increased monetary standards and crime prevention. However, the major benefits include the following:
1. Decreases a Variety of Criminal Activity
Demonetization has the advantage of reducing numerous types of criminal behavior. Old banknotes and coins are removed from circulation and may be ceased throughout the demonetization process, thereby losing their value. For organizations engaged in illegal activity, such as terrorism, the stored currency loses value since it is no longer accepted as legal cash.
For individuals involved in counterfeiting, banks will check to see if old banknotes are fake before exchanging them, enabling the government to eliminate fake money from the system.
2. Avoids Tax Fraud
Demonetisation of currency can also stop tax evasion since individuals doing so must trade their current money or run the danger of losing all of its value. The government can identify tax evaders and retroactively tax their unreported gains throughout the currency conversion procedure.
3. Encourages a Cashless Society
Demonetisation can accelerate the transition to a cashless economy by allowing the government to reduce the use of paper money and increase digital payment methods.
Negative Effects of Demonetization
On the other side, the demonetization process may have various drawbacks, such as:
- Printing expenses typically go up when old currency notes are replaced with newer ones. However, a nation’s or economy’s government pays for it.
- The goal of demonetization is primarily to eliminate black money from the economy. As a result, those who hold the equivalent amount in assets like gold, real estate, land, etc., are typically not affected by this regulation and get away with it.
- There is a lot of early turmoil caused by it. Since there are not so many banks available to serve the entire country, there will always be lengthy lines, lost workdays, and temporary losses for small firms.
- Due to the fact that even businesses struggle to handle their daily financial requirements for operations, many people must deal with problems like non-payment of salaries or delayed payments.
- Because consumers worry that there might not be any money in the market and begin to hoard it, the broader economy occasionally experiences cash shortages or liquidity issues.
- During such times, people’s purchasing power decreases, they tend to spend less, and many companies experience losses due to this.
- The cashless system might not always function since not all suppliers have the necessary infrastructure and technology, which can cause several issues even when purchasing basic supplies.
- The economy is slowed down because black money significantly contributes to GDP (gross domestic product) inflation.
The primary outcome is evaluated based on how ordinary people view it and adjust to it. Generally speaking, demonetization has also failed to help governments or leaders throughout the world to realize their grand dreams. To penalize the segment of society engaged in criminal activity, the government ultimately caused problems or difficulties for those who complied fully.
With India’s recent demonetization, a similar scenario was seen. Since 99% of the banned tenders were once again injected into the system, only the regular people had to suffer, and the fundamental goal was never achieved.
Saying this also does not imply that there were no beneficial effects. Terrorist activity has significantly decreased. The nation has examined various bank accounts and taxed several unaccounted cash holders, which finally worked to the nation’s advantage. It is up to the populace to perceive this trade-off favorably or negatively.
These policies are few when people think about their immediate benefits, but they are abundant when considering their long-term effects. Cash-intensive industries like FMCG, real estate, construction, etc., usually suffer the effects. But concurrently, improved financial inclusion and higher government investment will provide the economy with a long-term boost.
Examples from Real Life
1. India (2016)
India’s 2016 announcement that all 500 and 1,000 rupee banknotes would be discontinued is a recent example of demonetization. It was carried out to lessen the availability of fake money used to finance crime.
Cash was in limited supply all around the nation when the demonetization was announced as people rushed to swap their old banknotes. It caused economic disruptions, which decreased India’s industrial output and slowed the country’s GDP growth rate. However, everything came on track very soon.
2. Eurozone (2002)
The 2002 switchover in Europe to the euro was another instance of demonetization. The European Central Bank began producing banknotes and coins from the year 1998 to help with the process and ensure that there was enough money in circulation.
Later, the central bank started distributing the new banknotes and coins to banks several months before the euro was officially introduced to ensure that all citizens had access to the new currency.
How does the GDP affect Demonetization?
Demonetization often slows economic expansion and lowers GDP in the short run. Many industries and sectors can temporarily cease during the changeover process. The process of demonetization may prevent certain sectors from paying workers.
Once demonetization is complete, it frequently produces long-term economic advantages that eventually boost GDP. Demonetization aims to combat financial crime. By increasing transaction transparency or discouraging the exchange of counterfeit currency, a government is typically able to raise more tax revenue and make larger investments in their nation.
Other Instances for Demonetization
Demonetization, which is frequently related to social media, is another term for the corporate activity of withholding payment. Demonetization occurs when a platform’s content producer no longer qualifies for payment as a result of structural changes to the platform. This could happen due to a breach of the terms and conditions or owing to modifications made to the platform’s algorithms that choose which authors are qualified to receive compensation.
This method of demonetization is comparable to the method of ending legal tender, although applied in a completely different environment. For both, an asset that formerly had the value has lost that value due to changes to the item’s fundamental characteristics.
The Bottom Line
A government’s decision to demonetize currency is a bold and constructive move toward improving the economy and nation. However, it should be properly implemented and planned to prevent inconveniences for the general public and serious damage to the economy.