Demonetization

An economic process in which a country’s currency unit is no longer legal tender

What is Demonetization?

Demonetization is an economic process in which a country’s currency unit is no longer legal tender. A currency unit is what we would commonly refer to as physical money, such as banknotes and coins. When demonetization occurs, the country’s currency unit is essentially worthless, as it can no longer be used to purchase goods and services.

 

Demonetization

 

Demonetization can occur for several reasons, from a change in national currency to the retirement of older forms of money. Over time, several countries have implemented currency demonetization measures, albeit with varying degrees of success.

 

Summary

  • Demonetization is an economic process in which a country’s currency unit is no longer legal tender.
  • After a currency has been discontinued, it is no longer legal tender and contains no monetary value.
  • At times, countries may also decide to reinstate discontinued currency as legal tender through a process known as remonetization.

 

The Demonetization Process

Demonetization is a form of economic intervention, where a country moves to replace one form of currency with another. At the beginning of the demonetization process, the old currency is discontinued and pulled from circulation to be replaced with new forms of money.

During the process, people are given time to exchange their existing banknotes and coins for the new currency before it is officially discontinued. After a currency has been discontinued, it is no longer legal tender and contains no monetary value.

The demonetization process can occur in many different forms – a country can introduce new banknotes or coins or implement a completely new form of currency altogether. However, demonetization is a drastic measure that occurs rarely and can disrupt society if implemented improperly. At times, countries may also decide to reinstate discontinued currency as legal tender through a process known as remonetization.

 

Reasons for Demonetization

Although demonetization is rare, countries around the world have conducted demonetization measures for various reasons.

  • Governments may choose to undergo demonetization if the currency gets out of control, due to problems like hyperinflation.
  • Demonetization can also be used to prevent criminal actions, such as counterfeiting, terrorism, or tax evasion.
  • In other cases, demonetization occurs to implement a new currency standard. For example, in 2002, the European Union introduced the euro, a central currency that would replace the existing currencies of several nations. In adopting the common currency, countries across Europe discontinued their currencies and introduced the euro as the standard across the European Union.

 

Advantages of Demonetization

Through the demonetization of currency, a country can receive benefits ranging from crime prevention to greater currency standardization.

 

1. Reduces various criminal activities

One of the benefits of demonetization is the reduction of various forms of criminal activity. Through the demonetization process, old banknotes and coins are discontinued and taken out of circulation, and effectively become worthless. For groups conducting criminal activities, such as terrorism, their supply of money effectively becomes worthless, as the currency is no longer legal tender.

For those engaged in counterfeiting, the banks will evaluate whether old banknotes are counterfeit before exchanging them, therefore allowing the government to remove counterfeit currency from the system.

 

2. Prevents tax evasion

Demonetization of currency can also prevent tax evasion, as those that are evading taxes must exchange their existing currency or risk their money becoming worthless. In the currency exchange process, the government can catch those who have evaded taxes and retroactive tax their unreported earnings.

 

3. Promotes a cashless economy

Demonetization can also further the push towards a cashless economy, as the government can slow the circulation of physical currency and move towards more digital options.

 

Disadvantages of Demonetization

On the other hand, some disadvantages can arise from the demonetization process, including:

 

1. Incurs costs from printing new banknotes and minting of coins

One of the initial drawbacks is the costs involved with the printing of new banknotes and the minting of coins, as well as the discontinuation of existing currency.

 

2. May not entirely reduce criminal activity

In addition, demonetization may not reduce criminal activity, as criminals may keep their assets in other forms, such as gold or real estate.

 

3. Can trigger chaos among citizens

Finally, if the demonetization process isn’t implemented successfully, it can result in chaos among the population, as people scramble to exchange their currency before discontinuation.

 

Real-World Examples

 

1. India (2016)

A recent example of demonetization was India in 2016 when the government announced the discontinuation of all ₹500 and ₹1,000 banknotes. It was done to reduce the presence of counterfeit cash to fund criminal activity.

When the demonetization was announced, there were shortages of cash across the country, as people scrambled to exchange their existing banknotes. It led to disruptions to the economy, reducing India’s industrial production and hindering its GDP growth rate.

 

2. Eurozone (2002)

Another example of demonetization was the European transition to the euro in 2002. To facilitate the process, the European Central Bank needed to ensure that there was enough currency to be circulated and began printing banknotes and minting coins as early as 1998.

When the euro was introduced, the central bank ensured that all citizens were able to access to the new currency and began providing banks with the new banknotes and coins several months in advance.

 

Related Readings

CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Denomination
  • Gold Standard
  • Definitions of Money
  • Virtual Currency

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