Efficient Demonetization

What were the distributional consequences of the recent demonetization in India? Can the implementation of demonetization be improved to mitigate its distributional impact? This paper answers these questions using a dynamic contracting model featuring costly state verification and cash-in-advance constraints. Using an instrumental variables strategy, I document substantial heterogeneity in the impact of demonetization on consumption expenditure across income and wealth distributions. This finding suggests that the non-discriminatory transfer limits implemented during demonetization were too blunt to insure against idiosyncratic income risk. I propose sharper monetary policy instruments contingent on the history of reported household income to facilitate static and dynamic consumption smoothing. I isolate the conditions under which optimal state-contingent transfer limits are weakly decreasing in income and strictly increasing in wealth. A model calibrated to Indian data reveals that switching to a state-contingent monetary policy produces long-run gains in central bank surplus equal to 28.5% of aggregate income.