(AP File)
(AP File)

Opinion | Can we please have the 1,000 currency note back?

To optimize transactional efficiency, the next higher denomination of a note should be twice the value of the lower one

After the cab driver refused to take my 2000 note, I had to indulge in a giant chocolate bar just to get some change needed to pay for the cab ride. I am sure many have had similar experiences.

Sometimes we also have to give up on good bargains because of lack of change. Is it possible to make cash transactions less frustrating? To answer this question, we have to first ask a more fundamental question — why do we use money?

Older monetary economics textbooks explain that barter exchange leads to the problem of double coincidence of wants and money emerged as a solution.

The more recent answers to this question, however, demonstrate a much deeper role of money in the economy. For example, in an influential article, economist Narayana Kocherlakota argues that “money is memory", highlighting the fundamental record keeping function of money. Our work contributes to the economy. The money we receive serves as the record of this contribution. This record can be carried from one place to another and also across time.

Authors Kiyotaki & Moore propose “evil is the root of all money", suggesting that lack of trust or difficulty in verifying creditworthiness gives rise to demand for money. In a traditional village economy, for example, trades could be based on trust.

Trading between the villages however, needed something more- a universally acceptable medium of exchange like money. With that you could trade with a complete stranger.

So, lack of trust or probability of reneging on one’s promises — evil — leads to emergence of money. These reasons also suggest that money makes beneficial exchanges possible that otherwise would have to be forgone. With money, the total number of beneficial transactions increase. This is what economists mean by money being “essential".

The post demonetization jobs and output losses quite ably demonstrate the essentiality of cash in India.

Given that money is essential, are some currency denominations more “essential" than others?

Put differently, would changing the relative availability of various denominations have any impact on the total number of beneficial trades in the economy? One approach to answer this question focuses on spacing rules for currency denominations.

This follows the principle of least effort (PLE) which requires minimizing the number of monetary units (notes or coins) needed in a given exchange as well as its production cost.

Research shows that the optimal currency denomination structure is the spacing of factor 2, i.e. the higher denomination should be a multiple of 2 of the immediate lower denomination.

The Indian currency structure adheres to this to a considerable extent. The coinage is spaced as 1, 2, 5, 10 and first set of notes are spaced as 10, 20, 50, 100. This structure was implemented in the higher denominations with one exception till November 2016. We had 100, 500, 1000 but not 200.

After demonetization, the higher denomination structure became lopsided with addition of 2000 and removal of 1000, although addition of 200 was a welcome move.

The cab ride example demonstrates the practical consequences of not following the optimal spacing rule — unwanted or forgone trades.

My hunch is that such trades may have increased under the current denomination structure. As people prefer a mix of smaller denomination notes over one big note chances are, they will be reluctant to accept 2000 note in transactions.

This is because, in absence of an intermediate denomination between 500 and 2000, it becomes necessary for them to have more notes of 500 or less to be able to accept a 2000 note.

This increases the transaction costs of low value cash transactions and leads to efficiency loss in terms of lost/unwanted trades. It may have been a conscious choice by the government to make cash transactions costlier. However, with no fundamental changes in the economy to reduce dependence on cash, the government policy may have only caused substantial efficiency losses than gains.

Maybe I am overlooking the advantage of a large denomination note — reduced transaction cost of large cash transactions.

Arguably, an optimal currency denomination structure, has to consider the trade-off between the benefit of reduced transaction costs for higher value transactions and the increased transaction cost for lower valued transactions.

Given that households probably engage in low valued transactions more frequently than large value transactions, it might make more sense to increase volume of the lower denominations of 500, 200, and 100, phase out 2000 which most likely RBI seems to be doing and reintroduce 1000 note.

The 1000 note will provide some degree of economy in large value cash transactions, and yet economize on denominations required in exchange, making it more essential than 2000.

So why not go ahead and correct the course — drop 2000 and get 1000.

Parag Waknis teaches monetary economics at Ambedkar University , Delhi

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