Friday will mark three years since demonetisation was announced. This thread is not on its impact on the Indian economy but on a more technical issue in economics -- the nature of the money supply process. Demonetisation could be seen as a rare natural experiment in this context
The key question is -- what drives money supply growth? The monetarist view is that a central bank alters base money through changes in its balance sheet. The money multiplier then kicks in to generate broad money (M3) that is usually a multiple of base money (M0)
The Post Keynesian view is that bank lending creates M3 while the central bank adjusts its balance sheet to support credit demand. Money is thus endogenously created through economic activity rather than exogenously by the CB. Frankly, I am conflicted on which side is right.
Most central bank thinking is dominated by the monetarist view of the money supply process. The Bank of England seems to have moved into the Post Keynesian camp on this issue. Basil Moore wrote a fine book on this in the 1980s, "Verticalists and Horolizontalists"
Where does demonetisation fit in? It offers us a rare look into the money supply process. The collapse in Indian money supply after 8 November 2016 was a result of a decision by the central bank to extinguish a big part of its liabilities, ie high value currency
It was an exogenous decision by the CB that changed money supply, rather than a collapse in bank credit forcing the RBI to shrink base money. This needs to be checked with empirical models, but the causation seems to run from base money to credit rather than the other way around
The demonetisation episode seems to back the money multiplier rather than the credit money view of the money supply process. As I said earlier, I am conflicted on this tricky issue but am surprised more economists have not used the episode in the context of this old debate
A final point about the money multiplier. It has little analytical value, though its only behavioural complement -- how people hold money between cash and bank deposits -- can provide useful clues to the aggregate demand shock that India is now facing.
