In a country, its Gross Domestic Product (GDP) is the value of all goods and services created during the year. GDP equals the grand total of all money transactions in a year. The money transactions are made from the same money which goes from hand to hand again and again, day after day for paying for goods or services. The money in the system therefore is a fraction of GDP. The factor which correlates money to GDP is called the velocity of money.

                                            Money x Velocity = GDP.

Velocity is therefore the speed of transactions, determined by the number of times the same rupee goes around to create GDP. Velocity is an independent variable and depends on the mood of the people to spend or save money. When the sentiment is for saving and not spending, the velocity falls and consequently the GDP starts slipping down. To prevent this fall, RBI resorts to injecting new money into the economy by printing more notes and by buying Bonds of banks and of Govt., giving money against the paper promising to pay it back in the future. The money supply increases to prop up the GDP. But when the sentiment changes and people begin to spend more, the velocity increases resulting in inflation as the supply of goods and services cannot keep up with increased availability of money in the market. Prices zoom and the value of paper currency reduces. This is where the RBI steps in to increase the interest rates and to shrink the quantum of money supply. The cyclical swing of sentiment resulting in changing velocity of money is therefore the underlying reason for alternating phases of inflation and deflation in a country, commonly known as economic cycles.

In India, we could divide the velocity of money after demonetisation into 2 segments, (1) velocity in bank transactions and (2) velocity in cash currency transactions. The velocity of money in cash transactions has been severely affected due to shortage of paper currency in smaller denominations and the GDP component related to paper currency has therefore been adversely impacted. But the GDP component related to bank transactions has not been affected. Technology has given us the tools for very fast way of moving money through smartphones and internet. Electronic transfer of funds increases the velocity of money in the banking system. Govt.’s laudable efforts for encouraging electronic payments will therefore lead to a surge in the GDP.

Money supply in the economy is the second factor which affects GDP. RBI controls this money supply by operating the Fractional Reserve System. This requires Banks to keep only fraction of the money deposited with them and lend out the rest. This fraction is called the Statutory Liquidity Ratio or SLR. RBI is empowered to determine the SLR up to a maximum of 40%. Current SLR is fixed at 21%. This means that the banks can make loans of the money deposited with them to the extent of 79%. The money lent goes as deposit to another bank which can in turn lend again 79% of the 79%, i.e. 62.4% of the initial deposit making a total of 79 + 62.4 = 141.4% and so on. The total money at the end of all such subsequent lendings add up to 476% of the initial deposit. Therefore every deposit of Rs 1000 multiplies 4.76 times to create total money supply of Rs. 4760. In another example, in an extreme case, if the RBI reduces SLR to 1%, the banks can lend 99% of its deposits at every step which will aggregate the money supply to 100 times of the initial deposit. This will create a total of Rs 1,00,000 money from the initial deposit of Rs. 1000, thus growing the money supply astronomically. RBI therefore has an enormous power to increase the money supply almost infinitely. 

RBI acts as a 2 way reservoir for money with the banks. If the banks run short of money, they can borrow it from RBI on interest at what is known as the ‘Repo’ rate. On the other hand, if banks have too much money, they lend it back to RBI on interest at the ‘Reverse Repo’ rate. Both these interest rates and the SLR are determined by the RBI from time to time.

RBI therefore has the monetary tools it needs to control the economy. It can vary the SLR to control the amount of money and it can vary the Repo and Reverse Repo interest rates to control the cost of money.

India was not short of money before demonetisation. So what will the additional bank deposits do? After demonetisation of Rs. 500 and Rs. 1000 denomination notes, the deposits with the banks have gone up by Rs 15 lakh crores. The banks will find it impossible to lend this money out to businesses in a short time even by doing their utmost and putting out their best efforts. They will therefore park the excess money with RBI. RBI will pay interest at Reverse Repo rate to the banks and thus the deposited money will have an interest cost burden on the RBI. But the banks will withdraw their money from RBI as fast as they can lend it to others because they stand to earn much more by lending to businesses as compared to the interest which the RBI pays them.

As the banks go on a lending spree, there will be a spurt in economic activity. The increased deposits with the banks at current SLR of 21%, will have a multiplier effect of 4.76 times and the deposits of Rs. 15 lakh crores will grow the additional money supply to a staggering figure of Rs. 71.4 lakh crores. The money withdrawn from the banks will be out of the new currency notes being printed by the RBI (by increased Govt. spending with deficit financing) so it will not affect the money supply with the banks. Therefore even if the cash currency withdrawals are to the full extent of Rs. 15 lakh crores, it will not affect the money in the banking sector. The additional money supply of Rs. 76.4 lakh crores with the banks is really a huge amount  available with the banks to lend. In order to use this golden opportunity to increase their business manifold, the banks will make aggressive efforts to stimulate industry, businesses, traders, importers, exporters, builders, home buyers and literally everyone. They will give out more consumer loans and issue millions of debit and credit cards. There will be an explosion of financial activity all around. Demand for products will increase. Factories will expand their capacity, employment will be generated and India will prosper. Banks will be pushed to earn more by lending more to pay interest to their deposit holders. All this will happen quickly because the banks will do their utmost to prevent loss in their Balance Sheets.  

During this time, RBI will issue substantial and adequate number of currency notes to meet the demand of cash currency withdrawals. And the Govt. would have appreciated the increased funding by issuing more currency. Therefore, the cash currency segment of the economy will soon regain its velocity and the GDP segment related to cash currency will also flourish.

In conclusion, demonetisation was a blessing in disguise. The economy will boom sooner and grow bigger than one could have ever imagined. This will lead to enormous development in our country and lead to better standard of living for its entire population.