Efficient Demonetization
Speaker(s) Dr. Shiv Dixit from ISB, Hyderabad Publication CAFRAL Conference room on Mezzanine Floor, Main Building. Reserve Bank of India, Fort, Mumbai 400 001

Traditional models of money assume that the marginal social cost of printing fiat currency is zero, justifying the optimality of the Friedman rule. However, in an environment where the degree of hidden income is alleviated by the dearth of cash, demonetization could be efficient. To implement this policy, the Reserve Bank of India (RBI) imposed non-discriminatory transfer limits, which I argue are too blunt to insure against idiosyncratic income risk. I propose a set of instruments that provide a better hedge against such shocks - transfer limits dependent on reported household income. I isolate conditions under which optimal state-contingent transfer limits are monotonic in endowments and promised values. This framework successfully predicts the heterogeneous response of households to demonetization. A model disciplined by the distributions of wealth, income and consumption expenditure in India reveals that long-run gains in the surplus of the central bank upon switching to a state-contingent monetary policy from a non-state-contingent one are 28.5% of aggregate income.

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