** Forgive me for spelling errors and inconsistencies. They will be corrected soon.
***UPDATE: Some mistakes found and rectified
A friend of mine asked me a very interesting question concerning India's decision to demonetize and its recent monetary scheme which introduced a new Unified Payment Interface (UPI) aimed at easing domestic currency circulation. I responded with a rather rough understanding of the issue. This is strictly a normative exercise in which I tried to make sense of what the government of India and the Reserve Bank of India have been doing, their ultimate long-term goal, and the drawbacks of such highly experimental method.
Now, here is the problem in India that I am aware of, or of which I am aware (for grammar maniacs out there). India has a relatively underdeveloped central banking system and financial infrastructure in general (note the adverb "relatively"). The confidence in its fiat currency (the rupee) as a store of value is not up there yet. You know, unlike the American dollar or the European euro. So, the majority of households in India resort to saving by hoarding gold. This is rather unproductive. First, gold price swings mostly due to human emotion, resulting in less predictable and stable price than the properly managed fiat money. Second, following from the first reason, gold thus generates no steady return. Not to mention, it is gone if stolen. Third, gold cannot be loaned out for productive economic purposes. Indian households have their own personal gold storage, thus the potential loanable fund (from households' savings) is highly decentralized making it costly and virtually impossible to be borrowed by entrepreneurs and households who are seeking credit for business start-up/expansion.
Another obvious problem in India is the existence of a large informal sector - a sector not taxed and not regulated by the government - resulting in black money and tax evasion as additional dimensions of the issues that sorely need some sort of resolution.
I have not done that much reading for reference, but my guess is that the government of India somehow found out that the circulation of ₹500 and ₹1,000 combined is higher than the expected money in circulation given the GDP and growth of GDP figures. If you have more money flowing around than what is taxable and shown in the formal report, this hints at the possibility of having bulks of black money in the market. Okay, this is my unrefined sense of understanding of the situation. Again, I have only scratched the surface, and the article is mostly based on common logic employed in economics. So, as you read on, keep in mind that while the analysis seems precise, this is by no means an indicator of accuracy.
The solutions thus far
Back to the point. My thought is that I can see the logic behind demonetization (i.e. illegalizing them, taking them out of the circulation completely) of the ₹500 and ₹1,000 notes. This is again based on the premise that those holding onto black money (the corrupted) have heaps of the two mentioned notes. Thus, the seemingly appropriate response (the obvious) is to just remove them from circulation. Simply put, black money has no proof of earnings, no record of legal transaction, no clear sources. By repudiating them through firm national declaration and giving limited time to citizens to turn their ₹500 and ₹1,000 notes in to exchange for the newly printed notes, the primary goal is to make corrupters go bankrupt by eroding the purchasing power of a huge portion of the money that they possess.
This is not to say that I entirely agree with the steps taken. I simply share similar approaches used in the positive analysis of economics.
How about the UPI? Well, the main objective here, I suppose, is to get higher number of transactions recorded for tax purpose. Basically, better regulation, stronger enforcement. In theory, this equals less black money in circulation and higher tax revenue for the government (which leads to another challenge we will not discuss: how is Indian government when it comes to budget management?).
Also, there are two other important but connected objectives perceivable by any first year macroeconomics students out there. First, get more people to use banking service. But, Indian banking infrastructure broadly is still relatively underdeveloped, so execution is a different issue on its own. Second, improve velocity of money. Making money changes hand faster; thus, lubricates the economy better. All these will lower the interest rate and allow better inflation management in principle. There is a simple equation in macroeconomics to depict this phenomenon:
MxV = PxY
(known as the Quantity Theory of Money, QTM)
Where M stands for Money, V for Velocity of Money, P for Price and Y for Output/GDP.
If we take total differentiation (ignore this if you are not familiar with calculus), we get the following equation for growth rates for of the four elements:
%ΔM + %ΔV = %ΔP + %ΔY
Gm + Gv = Gp + Gy
G denotes Growth Rate
m,v,p,y are just money, velocity of money, price and output respectively.
Δ is a symbol for "change". For instance, ΔM means change in Money supply. (for those already familiar with calculus, "d" which represents instantaneous rate of change is what should be used here by convention, but I deliberately ignore this for the sake of simplicity)
All it is saying is that the nominal GDP (the total current value - measured using current price - of the economic output of the entire nation) is essentially the same as the total Money supply (M) multiplied by the velocity of money - the speed at which money is circulating around within the economy. The growth rate of the current nominal GDP, assuming constant price, thus is in line with the growth of the volume of money supply and how fast money moves around.
There is a rich story behind QTM. For instance, it is reasonable to assume constant V and Y in the short-run, thus zero growth for both. This effectively implies that the growth of money is positively linked to the growth of price (i.e. inflation). Therefore, having control over money supply will allow one to influence price level at least in the short-run. Furthermore, if we go with the Keynesian approach and assume short-run sticky prices (that is prices are fixed) when the economy is slacking (i.e. Y is below its potential level), then a quick remedy is to either raise money supply or velocity of money. This is exactly the purpose of UPI on top of the other objectives already mentioned.
The situation here is that the government removes the currency from circulation, causing money supply to shrink and this act also affects the velocity of money as many small vendors and retailers find it hard to accept the new notes, and the lack of the 500 and 1,000 notes itself makes transaction cumbersome. So, it is only natural that one might look for means to increase the velocity of money. UPI is by this argument a good response to increase output. If price is not sticky, then this move also helps alleviate deflationary pressure that can wreck the economy if left unattended.
New solutions, new problems
That being said, I think UPI is a leap too huge and the cost is spread mostly amongst lower income people. Does it get rid of black money? Maybe, maybe not. The direct honest answer is I don't know. The story is to be unveiled. Maybe temporarily yes. However, my flawed intuition tells me that this is a method that only scratches the surface. I highly doubt its effectiveness in curbing black money problem. Why?
Black money might have already been converted to gold/USD or stored in offshore bank account. A simple story that anyone can think of.
The more severe impact is that this highly experimental approach basically kills off two other types of black money. Untaxed earnings by citizens and savings by poor families - the group most likely involved in informal sector where earnings usually come with no record for legal purposes. With a huge informal sector, the government is actually giving a middle finger to small businesses, street vendors, and smallholders. The black money as in the corrupted money by the elite will return after awhile as they are usually the ones who are highly informed, can afford legal detour, and are better and more successful at tax avoidance and evasion. What India is doing now is like hunting for foxes by burning the entire forest. Does it make sense? That's up to you to decide.
In a cash-based society like India (that engages in transaction by using cold-hard cash), with more than a billion people, there bounds to be one fake currency note or two zillions flying around. Think about those who are victims of the fake money who now lose the ability to exchange the fake for the new money. UPI? Fake money not accepted. Although these people have done no evil, the government's iron-fist policy might have eroded a huge portion of their wealth.
This move by the Indian government also lowers people's confidence in India's central bank. A no no for those performing monetary oversight who sorely needs people's confidence to be effective. Plus, is UPI faster than paying with cash? As my friend pointed out, India's internet coverage is not uniform across the country. You bound to have many places with weak signal. The telecom infrastructure is now a part of the story as well. The ease of UPI thus relies on both the soft and physical infrastructure India has to offer its people. This determines how well-received UPI will be (which then affects V, the velocity of money).
I think UPI is probably a more politically apt decision. It really shows the public that the prime minister is vehemently fighting corruption. As for the economics, I am not entirely sure. My understanding is murky at best.
Conclusion (Just so I can end this)
To reiterate, demonetization is highly experimental. It takes courage to do great things. The same idea applies if you want to do stupid things. The bottom line is I would not do that in a developing nation with many of its citizens relating strongly to cash in hand and gold. This is a bit reckless of a government policy. I support the cause, but the approach is questionable for now. As mentioned, this is analogous to burning an entire forest just to catch a few foxes. Baby foxes.
Still, the discussion has been a rough analysis based on my incomplete and imperfect understanding of the issues India as a country is facing. I would not go as far as to say that Indian government and its central bank are not forward-looking. It is entirely possible that the desired outcome is one of the long-term. This however depends on the efficacy of the new platform/system/model, whatever you want to call it. It is important that you do not take my words as authoritative. Read and consider other dimensions of the problem I might have missed. Incorporate your own experience. Even better, doubt this article.