Demonetization: Meaning, Example, and How It Works

What Is Demonetization?

Demonetization is the act of stripping a currency unit of its status as legal tender. It occurs whenever there is a change in national currency. The current form or forms of money is pulled from circulation and retired, often to be replaced with new notes or coins. Sometimes, a country completely replaces the old currency with a new currency.

Understanding Demonetization

Removing the legal tender status of a unit of currency is a drastic intervention into an economy because it directly affects the medium of exchange used in all economic transactions. It can help stabilize existing problems, or it can cause chaos in an economy, especially if undertaken suddenly or without warning. That said, demonetization is undertaken by nations for a number of reasons.

Demonetization has been used to stabilize the value of a currency or combat inflation. The Coinage Act of 1873 demonetized silver as the legal tender of the United States, in favor of fully adopting the gold standard, in order to stave off disruptive inflation as large new silver deposits were discovered in the American West. Several coins, including a two-cent piece, three-cent piece, and half-dime were discontinued.

The withdrawal of silver from the economy resulted in a contraction of the money supply, which contributed to a recession throughout the country. In response to the recession and political pressure from farmers and from silver miners and refiners, the Bland-Allison Act remonetized silver as legal tender in 1878.

In a more modern example, the Zimbabwean government demonetized its dollar in 2015 as a way to combat the country’s hyperinflation. At its peak, Zimbabwe's hyperinflation reached month-over-month growth of 79.6 million percent growth and year-over-year growth of 89.7 sextillion percent. The three-month process involved expunging the Zimbabwean dollar from the country’s financial system and solidifying the U.S. dollar, the Botswana pula, and the South African rand as the country’s legal tender in a bid to stabilize the economy.

Some countries have demonetized currencies in order to facilitate trade or form currency unions. An example of demonetization for trade purposes occurred when the nations of the European Union officially began to use the euro as their everyday currencies in 2002. When the physical euro bills and coins were introduced, the old national currencies, such as the German mark, the French franc, and the Italian lira were demonetized. However, these varied currencies remained convertible into Euros at fixed exchange rates for a while to assure a smooth transition.

Pros and Cons of Demonetization

There are several advantages when a nation demonetizes its currency. Fraudulent financial practices may be minimized as individuals will be unable to exchange illegal tender with banks. This also includes the potential reduction in tax evasion, pumping additional revenue into a nation's economy.

Demonetizing physical paper tender also demonstrates an advancing banking system, as digital currency can be more accessible, safer to store, and easier to transfer ownership. Organized industries and companies often benefit the greatest due to an easier transition.

Demonetization isn't without its faults. It's inconvenient for the nation's citizens and may be confusing when only select denominations are phased out over time. As a result of the disturbance, a nation's economy may temporarily experience a period of stalled growth in the short-term as the demonetization process occurs.

There are costly logistical measures to be taken as well. ATMs and other means of disbursing cash must be modified and recoded. Consumer prices must be reframed to ensure proper change can be given if needed. Daily wage earners—often among the poorest with no to minimal savings—may continue to be paid in defunct tender and must miss work to exchange their earnings with a bank.

Demonetization Example in India

Lastly, demonetization has been tried as a tool to modernize a cash-dependent developing economy and to combat corruption and crime (counterfeiting, tax evasion). In 2016, the Indian government decided to demonetize the 500- and 1000- rupee notes, the two biggest denominations in its currency system; these notes accounted for 86% of the country’s circulating cash.

With little warning, India's Prime Minister Narendra Modi announced to the citizenry on Nov. 8, 2016, that those notes were worthless, effective immediately—and they had until the end of the year to deposit or exchange them for newly introduced 2000 rupee and 500 rupee bills.

Chaos ensued in the cash-dependent economy (some 78% of all Indian customer transactions are in cash), as long, snaking lines formed outside ATMs and banks, which had to shut down for a day. The new rupee notes have different specifications, including size and thickness, requiring re-calibration of ATMs: only 60% of the country’s 200,000 ATMs were operational. Even those dispensing bills of lower denominations faced shortages. The government’s restriction on daily withdrawal amounts added to the misery, though a waiver on transaction fees did help a bit. Severe cash shortages were recurring even through 2018.

Small businesses and households struggled to find cash and reports of daily wage workers not receiving their dues surfaced. The rupee fell sharply against the dollar. 

The government’s goal (and rationale for the abrupt announcement) was to combat India's thriving underground economy on several fronts: eradicate counterfeit currency, fight tax evasion (only 1% of the population pays taxes), eliminate black money gained from money laundering, and terrorist financing activities, and to promote a cashless economy.

Individuals and entities with huge sums of black money gotten from parallel cash systems were forced to take their large-denomination notes to a bank, which was by law required to acquire tax information on them. If the owner could not provide proof of making any tax payments on the cash, a penalty of 200% of the owed amount was imposed.

Other Uses of Demonetization

Demonetization can also refer to the business practice of denying payment and is often experienced related to social media. Demonetization happens when a platform's content creator used to receive payment but due to underlying changes in the platform are no longer eligible. This may occur due to a terms and conditions violation or due to changes in the platform's algorithms that determine which creators are eligible to earn revenue.

Although used in an entirely different context, this form of demonetization is similar to the form of discontinuing legal tender. For both, an asset once held value but due to underlying changes in the nature of the asset, it no longer holds any monetary value.