Cash and the Economy: Evidence from India’s Demonetization

We analyze a unique episode in the history of monetary economics, the 2016 Indian “demonetization.” This policy made 86% of cash in circulation illegal tender overnight, with new notes gradually introduced over the next several months. We present a model of demonetization where agents hold cash both to satisfy a cash-in-advance constraint and for tax evasion purposes. We test the predictions of the model in the cross-section of Indian districts using several novel data sets including: the geographic distribution of demonetized and new notes for causal inference; night light activity and employment surveys to measure economic activity including in the informal sector; debit/credit cards and e-wallet transactions data; and banking data on deposit and credit growth. Districts experiencing more severe demonetization had relative reductions in economic activity, faster adoption of alternative payment technologies, and lower bank credit growth. The cross-sectional responses cumulate to a contraction in aggregate employment and night lights–based output due to the the cash shortage of at least 2 percentage points and of bank credit of 2 percentage points in 2016Q4 relative to their counterfactual paths, effects that dissipate over the next few months. Our analysis rejects monetary neutrality using a large-scale natural experiment, something that is still rare in the vast literature on the effects of monetary policy.