The Supply-Side Effects of India’s Demonetization

Abstract

I study the supply-side effects of a unique monetary shock – the 2016 Indian demonetization – that made 86% of currency in circulation illegal overnight. Exploiting cross-sectional variation in firm and industry characteristics that correlate with cash usage and exposure to the informal sector, I find that firms that use cash more and obtain larger shares of labor or material inputs from the informal sector, experienced declines in their labor and material shares after demonetization. I also show that casual laborers were more likely to report being unemployed in the months following demonetization. These findings document a supply channel for demonetization and also show that cash plays an essential role in India’s informal sector. Crucially, given that India’s formal sector is highly dependent on the informal sector for labor and materials, any shock to the supply of cash is likely to have affected the economy as a whole.