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Ananya Juluri

What is GDP? How did demonetisation affect it ?

Vivekanand Vellanki

Definition from Wikipedia: Gross domestic (GDP) is a monetary measure of the market value of all the final goods and services produced in a period (quarterly or yearly) of time.

Lets say you own a factory that produces soap. You make 1000 bars of soap daily that is sold in the local retail store. Lets say the market value of a bar of soap is 20/-. Your factory's contribution to the GDP is 20,000/- per day.

Note the word "final" in the definition of GDP. Since the factory will buy raw material to make soap - you have to subtract the cost of that raw material while computing the contribution to GDP. Although your final product is the soap, the addition to GDP you contributed has to subtract the market value of the raw materials.

Soap is an example of a good. Services are slightly different.

Lets say you visit the barber and get a hair cut. The barber has not sold you a good, the barber has offered a service for which you paid. The market value of the hair cut is the barber's contribution to the GDP. Of course, the barber uses some goods (e.g. oil, blade, A/C in his shop) and the market value of these has to be subtracted.

Lets go back to your soap factory example. Lets say, something changed and people are no longer buying your soap - may be, they decided to use a natural alternative, or decided not to use soap, etc. Now, you are able to sell only 500 bars of soap daily in the market. After 2-3 days, you will figure this out and reduce the factory output to 500 bars of soap. This has reduced your factory's contribution to the GDP by half.

Similar thing happened during demonetisation. While this has become very political, let me try to stick to the basics.

Effectively demonetisation forced people to return cash to the banks. The Indian economy runs on cash - i.e., most people pay for goods and services using cash. After demonetisation when cash was scarce, the demand for soaps would reduce.

When money becomes scarce to spend, people buy less things and use less services. In economics terms, people revert to buying only the essentials - food, water, etc. Purchase of things like mobile phones, restaurant dinners, etc are postponed - this has an overall effect of reducing the market value of goods and services produced (GDP).

Of course, the analysis is not this simple due to various other factors:

  • Use of credit cards in urban areas
  • Use of credit in various places (where the shop keeper trusted the customer, the shop keeper made notes of how much was owed). Of course, the shop keeper is still running short of money to stock up his store

There are longer term effects of demonetisation on GDP - it was not limited to just the period of cash scarcity.

Going back to the soap factory example, if the output of the factory is reduced to 500 bars of soap per day, as a factory owner you would be tempted to reduce the number of workers. As a result, lot of people lost jobs since the factories were not producing enough.

Farmers were also badly effected. Farming is seasonal - i.e. the land is tilled and seeds are planted before the rains, fertiliser is used based on plant growth, etc. Although, demonetisation was announced in the off-peak season for farming, it still had an impact on farming (it could have been worse of demonetisation was done before the rains).

Due to shortage of cash, purchase of seeds and fertilisers was impacted. Even hiring people to till the land, or sow seeds was impacted because cash was scarce. This means that large tracts of farm land were not growing anything - this leads to a loss of GDP since the farm output has market value that is added to the GDP.

Sangeetha Pulapaka

Demonetization is the act of stripping a currency unit of its status as legal tender. It occurs whenever there is a change of national currency. The current form or forms of money is pulled from circulation and retired, often to be replaced with new notes or coins. Sometimes, a country completely replaces the old currency with new currency.

In 2016, the Indian government decided to demonetize the 500 and 1000 rupee notes, the two biggest denominations in its currency system; these notes accounted for 86% of the country‚Äôs circulating cash. With little warning, India's Prime Minister Narendra Modi announced to the citizenry on Nov. 8 that those notes were worthless, effective immediately  Chaos ensued in the cash-dependent economy (some 78% of all Indian customer transactions are in cash), as long, snaking lines formed outside ATMs and banks which had to shut down for a day.

Barely six months after demonetisation, India's Gross Domestic Product or GDP growth rate has slumped down to 6.1 per cent in the January-March period, lowest in more than two years. This growth rate was unexpected as the Central Statistics Office earlier in January had estimated 7.1 per cent growth as compared to the 7.6 per cent in 2015-16. With this March quarter report, India lost its status as the world's fastest growing major economy.

The costs of this exercise have far outweighed the gains in the form of a very severe hit on the informal economy (big employer to millions of workers), destruction of supply chains, job losses and revenue loss to the Reserve Bank of India (RBI) that also showed in low dividend payments to the government. These apart, the pain inflicted on the common man who was forced to stand in serpentine queues for months on end to withdraw own money, alleged loss of lives and loss of income streams are not measurable using conventional economic tools. In hindsight, a cost-benefit analysis of the exercise makes one wonder whether the economy (which as limping back to health) really needed such a massively disruptive shock-therapy that inflicted pain on every constituent of economy, with no clear gains