RBI Should Make the Cash Crunch Permanent

Many states of India are again experiencing situation like demonetization of 2016. ATMs all across India are running dry and we are seeing long lines outside banks. The finance minister Mr. Arun Jaitley said that this shortage of cash is because of unusual sudden spike in the demand for money. Newspapers are citing causes related with supply where RBI failed to print enough currency notes despite warnings from the commercial banks. A cash crunch like this is surely a combined effect of both demand and supply side factors.

Government has asked RBI to ramp up printing of currency notes in the aftermath of this cash crunch. According to the latest report, RBI is gearing up to print up to 1 lakh crore new notes to plug the cash gap. This is a big mistake. This cash crunch can be a boon in disguise. If this crunch continues then, in the long run, it can result into lower prices of all consumer and producer goods, which will increase the standard of living of Indians. How? Let us see.

The price of any commodity is determined by four factors combined together. Two factors are from the commodity side and two from the money side. These four factors are: 1) demand for and supply of commodity, and 2) demand for and supply of money. Price of any commodity is an exchange ratio of that commodity with the other commodity with which it is exchanging e.g., if Crusoe exchanges 2 fish for 4 coconut of Friday then the price of 1 fish is 2 coconuts and the price of 1 coconut is half fish. When we are in the indirect exchange money economy the one common commodity exchanging against all other commodities is money commodity (historically gold and silver). The price of every commodity in money economy is thus expressed in terms of money commodity e.g., if 2 fish are exchanging against 20 rupees then the price of 1 fish is 10 rupees.

The laws of demand and supply tell us what the price of any commodity will be. Other things being constant, when demand will increase, price will increase and vice versa; and when supply will increase price will decrease and vice versa.

Now as I said above, the price of any commodity, say like an apple or an orange, is determined by four factors: demand for and supply of commodity and demand for and supply of money commodity. Let us use an example of an apple here. Other factors remaining unchanged, rise in the demand for apple will lead to rise in the price of apple. Fall in the  demand for apple will lead to fall in the price of apple. Increase in the supply of apple will lead to fall in the price of apple, and fall in supply of apple will lead to rise in the price of apple. Similarly, rise in the demand for money (people keeping more cash balance in home), while other three factors remaining unchanged, will lead to fall in the price of apple. This because increased demand for money increases its price i.e., its purchasing power in terms of other commodities like apple. We have to remember here that the money commodity also has a price like other commodities, and that price is its purchasing power i.e., how much other commodities it can buy. A fall in the demand for money will lead to rise in the price of apple. A fall in the supply of money will lead to higher purchasing power of money and lower price of apple. An increase in the supply of money will lead to lower purchasing power of money and higher price of apple.

The on-going cash crunch means two things: One, higher demand for money, in the form of people hoarding more cash balance, and two, reduced supply because RBI is not printing fresh currency notes. And both things mean, as we have seen above, higher price of money i.e., higher purchasing power and conversely lower prices of consumer and producer goods. If the cash crunch continues for long then, under the assumption that other three factors do not change drastically, slowly the prices of all other consumer and producer goods will start to fall in the market. If RBI is not printing fresh currency notes and people continue to hoard cash then the purchasing power of rupee notes in the market must rise i.e., the prices of other commodities must fall. Of course, this effect will only be seen under the given assumption of other factors not changing drastically. If they change drastically then prices may either rise or fall. We need concrete data of the rate of rise and fall in those factors to decide the end effect on consumer and producer good prices.

Notwithstanding the change in other factors, one thing is certain that if RBI stops printing any more currency notes and people continue to hoard cash then prices of consumer and producer goods will fall. This fall in prices will be a boon for Indians. Falling prices means higher real income i.e., a person either needs less rupees to buy the same amount of goods that he was previously buying or with the use of same rupee notes that he holds he can buy more goods. In either case Indians will become truly rich.