Monday, November 14, 2016

The demonetisation and central bank balance sheet

The debate surrounding the consequences of demonetisation in India, especially on the claims that it would lower RBI's liabilities or shrink its assets, create windfall profits for the RBI, cut fiscal deficit, reduce the base money, make the central swap money and non-monetary liabilities (commercial bank reserves, general reserves and capital) etc, are completely off kilter. It reflects a very basic ignorance of the central bank balance sheet, especially about how money is created and how it reflects on the central bank's liabilities side. 

This from the BoE primer about the central bank balance sheet nails it,
In most economies bank notes enter circulation through commercial banks. The process involves commercial banks drawing down banknotes in exchange for reserve balances held at the central bank. The wider population then obtains banknotes either through direct withdrawals from commercial banks or from other agents. Most central banks targeting price targets will supply banknotes on demand to commercial banks... While it is true that an individual commercial bank is free to choose between reserves and other assets, at the system-wide level the quantity of reserves is determined by accounting identities on the central bank’s balance sheet. 
In other words, once the money enters the market, it reflects on the individual balance sheet of commercial bank drawing it (and creating the proportionate reserves with the central bank, either from its own excess/free reserves or borrowing another's reserves). This claim can never be extinguished unless the underlying economic activity (or that part of the nominal GDP) is itself extinguished, and here too the process will be circuitous and play itself out through multiplier effects.

While as a step to address the challenge of black money, demonetisation is laudable and justified, these "killing 3-4 bids with one stone" arguments are just plain plain wrong. Market expectations are being formed on no foundations. 

1 comment:

Suvojit Chattopadhyay said...

Would you still say demonetisation as done in India is a good way to fight black money?