How currency in circulation impacts GDP growth?

22 May 2023 , 03:30 PM

The RBI recently announced the demonetization of Rs 2000 notes from 30^th September, 2023. It is still not clear how this move will impact the economy. To understand this better, the identity used by monetarist approach can be looked into. Monetarist approach says that in the short-term money supply is the real determinant of GDP. The equation that is used to define this relationship is MV = PQ.

The above equation is actually an identity. An identity is something that is meant to hold true in every situation. M in the above equation is Money supply. This includes the currency and coins that are in circulation, besides deposits in banks, money market funds etc. V in the equation is velocity of money. Velocity of money is the number of times on average in a year a unit of money (say, Re 1 or $1) changes hands for purchase of goods and services in the economy. P in the equation is price level. And Q is the quantity of goods and services produced in the economy. So PQ (the product of price and quantity) is the GDP of the economy.

According to this monetary identity, when M or V or both go down, GDP also goes down. Demonetization has the impact of reducing both money supply (M) and Velocity (V). People tend to slow down spending when they have lesser cash due to demonetization. This in turn brings down the velocity of money in the economy too. That is why the previous demonetization in 2016 slowed down economic growth.

The current demonetization of Rs 2,000 notes is of a much limited scale. Rs 2000 notes make only 10.8% of the total currency in circulation currently. In 2016, 86% of the currency in circulation was demonetized. This resulted in lowering of both money supply and velocity at that time.

 This time the RBI is likely to offset the impact on money supply or circulation, of Rs 2000 note demonetization, by increasing the circulation of currency notes of other denomination, such as Rs 500 notes. In the morning of 19^th May, the central bank had increased money supply by Rs 50,000 crore by doing a repo auction. Demonetization decision was announced in the evening of 19^th. 

How this decision will affect the velocity of money in the economy will actually determine the impact of this decision on economic growth and GDP. But the impact on velocity is also likely to be marginal.