Black Economy and Demonetisation

Dipankar Dasgupta’s “Theoretical Analysis of ‘Demonetisation’” (EPW, 17 December 2016) makes an attempt to explain the macroeconomic impact of demonetisation on key macroeconomic variables, particularly interest rate, along with other variables such as output, inflation, and exchange rate in the emerging context in India. Rightly, the author admits that the study of the long-term consequences of demonetisation would require elaborate and rigorous investigation at the both levels, theoretical, as well as empirical.

In this short response, I would like to draw attention to the fundamentals of macroeconomic model building—consumption function and money demand function—along with brief remarks on investment behaviour and money supply in the presence of black economy with reference to the macromodel suggested by Dasgupta.

Consumption Function

It is well-recognised in literature that there are differences in the consumption behaviours of households out of white incomes and black incomes (Peacock and Shaw 1982; Kumar 2002; Chattopadhyay 2012). These differences arise due to the mechanisms involved in black income generation along with the aspect of its illegality as compared to white income. Black incomes are best defined as tax-evaded factor incomes and property incomes. Bribes associated with corruption are essentially transfers, and hence need not be included in the definition of black incomes or black gross domestic product (GDP) (Kumar 1999). Black incomes generated in illegal sectors such as drug trafficking and smuggling that are not considered in the estimation of GDP depend entirely on cash. The government claims that demonetisation has virtually destroyed the operation of these illegal sectors.

It is generally argued that marginal propensity to consume out of black income is higher than that out of white income (Peacock and Shaw 1982; Kumar 2002). Further, white consumption is assumed to be a lagged function of income, whereas black consumption would respond to black income with a much shorter lag duration. Higher marginal propensity to consume out of black income would apparently raise the value of the multiplier. However, in the long run, black investments tend to be unproductive and constitute leakages from the circular flow of income within the economy (for instance, black investment channelised towards non-reproducible assets such as land, and/or out of the country through smuggling and drug trafficking facilitated by the havala route). This coupled with distribution of income shifting in favour of the rich and propertied, due to black income generation, would raise the marginal propensity to save that would dampen the income generation (Kumar 2002; Chattopadhyay 2012).

Post Demonetisation

Consequent upon demonetisation, there was a sudden spurt in consumption immediately after 8 November 2016, as people disposed their savings held in old currency notes of ₹500 and ₹1,000 by buying gold and other consumable goods so as to deposit less in their accounts, possibly to avoid the gaze of the income tax authorities. This also resulted, in the process, eliminating the stock of black incomes held in the cash. There have been quite a good number of cases reported where black cash arguably has been deposited in the accounts of others and/or by opening new accounts. It now appears quite clearly that the government thinks unless these cases are detected and pursued by the income tax authorities, tackling corruption by taking recourse to demonetisation would remain virtually ineffective.

While formulating the consumption function in an economy with substantial black incomes, it is important to take note of the fact that white consumption is a function of income held in the form of both cash and deposits (assuming away consumption loans), but black consumption is primarily a function of income which is held in the form of cash.

This possibly had a role to play and to even lead to a depression of demand—both white as well as black consumption. Even as mainstream macroeconomists often claim that the black economy in India is a parallel economy, and are reluctant to incorporate it in macro-modelling, black and the white economies are in fact intertwined (Kumar 2002). Post demonetisation, white consumption in particular has suffered as the distinction between the forms in which incomes are held, whether in cash or in the form of bank deposits, became crucial for determining spending. This is to an extent being captured by the variable in the consumption function that captures the ease of transaction.

While confidence has been incorporated in the consumption function, it is no less important for the investment function. The consumption function hypothesised by Dasgupta (2016: 69) is as follows:

C = C (Y, i+ρ, e, φ, W) + I (i+ρ, e) + G

Once we recognise that as black incomes are generated in the economy along with the white income, consumption and investment are required to be split into a white and a black component. Thus,

Y = C (Y_w,Y_b, i+ρ, i_b e, φ, W (both black and white)) + I (i+ρ, e, φ, g(Y_w,Y_b)) + G

So the above equation has been modified to restrict my response to the suggested model by Dasgupta to show explicitly, the existence of the white and the black, and how they would impact the white GDP. A complete model should ideally deal with both white and black GDP. Since there are channels of black investment, the complete model would also entail making a distinction between black investment and white investment, and therefore both have to be formulated differently (Kumar 2002; Chattopadhyay 2012).

Money Demand Function

The Keynesian money demand function and money supply function also need to be revisited in the presence of black economy. Since, black savings out of black incomes are held in cash, and arguably the propensity to hold cash is more than that of white due to black incomes, the demand for money would go up in presence of black incomes. In fact, demonetisation has targeted to extinguish only a small part of black savings held in the form of cash. There are many channels of black investment out of black incomes as suggested by Kumar (2002) which have escaped the wrath of demonetisation.

In the Keynesian demand for money function, we have mainly three sources: transaction, precautionary, and speculative demands. The additional source of demand arising out of black incomes needs to be included at least as a parameter in the present context which will shift the negatively sloped money demand function rightward.

(M/P)^d = M/P(Y_w, i, Y_b)

It is possible that the demand for money will continue to remain high as people will try to satisfy the precautionary demand for money they had during the pre-demonetisation phase, and that is perhaps why the banks were not in favour of raising the withdrawal limit beyond ₹2,500 per day from the ATM. Treating the money supply function as vertical and horizontal is also contestable. The very fact that the Reserve Bank of India (RBI) has responded to the steady rise in the demand for currency (arising out of black incomes as well) provides the rationale for demonetisation. This brings into question the vertical money supply function. In fact while determining the rate of interest, we need to take into account the operation of the informal money market which uses up the currency and hence reduces the effective volume of real money supply for the determination of i in the formal money market.

Applicability of IS–LM Model

The intersection of the IS (investment savings) and the LM (liquidity money) curves assumes that both the goods market and the money market are in equilibrium together. Applicability of this conventional macro-apparatus in the context of demonetisation is a little problematic. Demonetisation which can be construed as an unanticipated shock in the form of monetary contraction (Dasgupta 2016) in effect has disturbed the goods market equilibrium because it has shown that the form of consumption (cash or directly credited to the bank account) matters significantly. This necessitated the inclusion of e (“ease of carrying out transactions”) in the proposed consumption function. So a leftward shift in the LM curve must have disturbed the IS curve as well which questions the applicability of the IS–LM model in the context of demonetisation. This problem is intrinsic to the IS–LM model as equilibrium in the goods market is a flow equilibrium whereas equilibrium in the money market is a stock equilibrium, and yet they are fitted together.

Further, determination of the rate of interest is largely administered by monetary policy announced by the RBI from time to time. The distinction between stock and flow remains to be important in the larger context as black money is a stock, while black income is a flow. The generation of black income is sustained by the machineries and the rules which the government should now focus on to tackle the menace of illegalities.

References

Chattopadhyay, Saumen (2012): Macroeconomic Disequilibrium and the Black Economy: The Indian Context, Germany: Lambert Academic Publishing, Macroeconomic Dis-equilibrium and the Black Economy in the Context of Stabilisation Policy in India, Diss, New Delhi: Jawaharlal Nehru University, 2002.

Dasgupta, Dipankar (2016): “Theoretical Analysis of Demonetisation,” Economic & Political Weekly, Vol 51, No 51, pp 67–71.

Kumar, Arun (1999): “The Black Economy: Missing Dimension of Macro Policy-Making in India,” Economic & Political Weekly, Vol 34, No 12, pp 681–94.

— (2002): The Black Economy in India, New Delhi: Penguin Books.

Peacock, A T and G K Shaw (1982): “Tax Evasion and Tax Revenue Loss,” Public Finance (Finance Publiques), Vol 37, No 2, pp 269–78.