Arun Jaitley, India’s Finance Minister, has indicated that perhaps not all of the junked money in the form of those Rs 500 and Rs 1,000 notes demonetised will be reissued. There’s a possibility that digital money–by which he really means digital payment systems, not alt-currencies like Bitcoin–will take up the financing needs of the economy instead. It’s not obvious that this is a wise decision. It’s certainly possible that there will be more use of credit and debit cards, mobile phone banking systems and apps and so on but that’s not really how we should work out how much money the economy needs. Simply put the government should provide the amount of cash that the economy wants, not try to use the cash supply to get the economy to do what the government wants.

Thus this might not be a good idea:

Finance Minister Arun Jaitley today hinted that not all of the Rs 15.44 lakh crore worth of currency junked will be remonetised through issuance of new notes as he said digital currency will fill the gap.

Calling the scrapping of old 500 and 1,000 rupee notes as "a courageous step", he said the government could do it as India today has the capacity to take such decisions and experiment boldly.

We can all see what is desired here. There is that general move to try to wean the Indian economy off cash as the means of payment and to try to get more of the economy working in that digital manner. In part this is highly desirable–getting the entire population banked for example would mean that the welfare system could be the very much more efficient distribution of money rather than the current cumbersome, expensive and corrupt system of the distribution of goods. So it’s a reasonable goal to aim for.

But specifically and deliberately limiting the amount of cash in order to drive this change isn’t the way to do it.

“One of the efforts of this exercise has to be that even though a reduced cash currency could remain, our conscious effort… (is) to supplement the rest with a digital currency,” he said. Once the remonetisation process is complete, it will mark “the creation of a new Indian normal because the normal that existed for 70 years is an unacceptable normal,” he added.

That goal, less cash and more banking in the economy is an entirely fine one. It’s just that forcing it is not the right way to do. And forcing it by deliberately reducing the amount of cash available really, really, isn’t the way to do it. The government’s duty as far as cash is concerned is, under a fiat money system, to produce as much as the economy demands. No more than that as that creates inflation, but no less than that too. Money exists in order to allow the economy to take place–don’t limit the amount of it because to do so will reduce the amount of that economy which will take place.

In formal terms this is our old friend MV = PQ, cash money times velocity of circulation equals GDP (to roughly recast the equation into an unfamiliar form). It’s true that if that velocity, which here we can think of as an increase in digital transactions, increases then less cash money is needed. But we want the equation to be determined that way–not let us deliberately reduce cash so that velocity increases. Because that risks the effect coming out on the other side of said equation.

There is also another point here, which is that a growing economy needs a growing money supply. The analogy is to a restaurant. Normally it serves 50 meals each lunchtime with, perhaps, a stock of 50 plates. Now trade improves and it serves 100 meals a day. It’s entirely possible to wash those 50 plates faster to do that serving–but a rational restaurant owner will almost certainly decide to increase his stock of plates. That washing is the velocity of circulation, the plates are the stock of the money supply. A growing economy might well see a change in velocity–but we do generally think that the money supply should increase in line with economic growth. India’s economy is growing strongly–thus the money supply should be too.

Again, please note, I am not saying that the desire for more digital transactions is a bad one, it isn’t. Rather, that deliberately restricting cash money supply in order to achieve that might not be all that good a decision.