What Is Demonetization?

Demonetization is the act of removing a currency from use as legal tender.

How Demonetization Works

Demonetization occurs when a governing body cancels the legal tender status of a currency unit in circulation. This can occur if an economy is struggling against inflation or deflation, or against some form of corruption. Demonetization is also used to hinder a cash-dependent economy or encourage trade.

Demonetization Example

In a recent example of demonetization, the Indian Government in 2016 removed its 500 and 1,000 INR notes, making them no longer valid as currency. The government implemented this action to stop the flow of financing to terrorists, reduce interest rates in the banking system, assist in the creation of a cashless economy, and spotlight tax money not paid to the government.

Why Demonetization Matters

Taking a unit of currency out of circulation is usually a drastic measure that sends significant reverberations throughout an economy due to the vast number of economic transactions the currency touches. Demonetization can potentially create economic chaos and spiral a nation into a recession.

On the other hand, demonetization has been used as a productive mechanism for stabilizing and sustaining a new form of currency, combating inflation, enhancing trade and introducing new access to markets, and transitioning informal economic activity away from underground or shadow markets.

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Rachel Siegel, CFA
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Rachel Siegel, CFA is one of the nation's leading experts at ensuring the accuracy of financial and economic text. Her prestigious background includes over 10 years creating professional financial certification exams and another 20 years of college-level teaching.

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