Two years before the Morarji Desai government scrapped high-denomination notes, two Delhi School of Economics economists- K. Sundaram and V. Pandit, published a paper analysing the impact of demonetisation on black economy. Some key points they made in the paper that appeared in the Indian Economic Review on October 1976 are as follows:
Acquiring black money: It arises from the evasion of both direct and indirect taxes. The difference between ‘stock’ and ‘flow’ of black money is crucial to understand the working of a black economy.
Black incomes are more common in countries where the economy depends on planning, and particularly where significant price controls and quotas are placed on commodities. The margin between price controls and market-clearing prices form the major part of black income. India is a perfect example.
Saving black money: Most commonly, it takes the form of cash, gold, and inventories of goods. Black income can also be utilised in capital equipment by understating the value of the equipment and then paying the difference between the commodity’s true value and declared value through black savings. A majority of black savings are spent in the unorganised sector, giving rise to a further “flow of structural black income”.
Demonetisation to deal with black income: It is advocated on the assumption that holders of black liquidity assets would want to present only a small portion of their savings for conversion. The success of this policy depends on the amount of black savings has been held in the denomination of demonetised currency. If a significant part is held as gold etc., it will not have any effect.
The policy will not be any good if it is anticipated in advance, in which case conversions of liquid assets to other commodities such as gold would be made. In order to be successful, demonetisation has to be accompanied with a ban on trading in all these assets.
While demonetisation might have an impact upon the ‘stock’, it will not have much effect on the ‘flow’ of black money. However, it will lead to lowering of demand for goods from holders of black liquidity, thereby cutting inflation, and so increasing confidence in the government.