Demonetization occurs whenever a country changes their legal currency, stripping the previous currency of its status as legal tender. This is a fairly drastic move in economic policy, which does not happen frequently especially in the modern world. The old 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, and other times, a currency may simply be updated or a single denomination or coin may be pulled from circulation. This step can be used to stabilize an economy, but if performed incorrectly it can itself cause instability or economic panic. Most often, demonetization either occurs as a way of combating inflation or as a way of facilitating international trade.
Examples of Demonetization
The most prominent example of demonetization that has occurred within the last few decades occurred in Europe, as various countries stripped their local currency of value in favor of the Euro, thus facilitating the European Single Market and further integrating the member states of the European Union. In this case, currencies such as the Deutschmark, French Franc, and Dutch Guilder (among others) lost their status as legal tender, though during a fixed period of time they could still be exchanged for euros at fixed rates.
Demonetization has also occurred recently in India. In an attempt to decrease fraud and centralize a highly cash-based economy, the Indian governemnt stripped the two highest denominations of their currency, the Indian rupee, of value, forcing people to use smaller bills for all cash transactions. Unfortunately, this policy change led to widespread chaos and even today India still sees a shortage of cash and of ATMs that are compatible with the newly-introduced bills.
Benefits & Risks
In some countries, demonetization has been used to stabilize the value of a currency or combat inflation. Other countries have demonetized currencies in order to facilitate trade or form currency unions, as was the case in Europe. Lastly, demonetization has been used as a tool to modernize a cash-dependent developing economy and to combat corruption and crime. The main drawback to demoneitzation is the cost involved in minting the new currency. Also, the strategy may not have the intended effect of reducing criminal activity as they may be savvy enough to hold assets in other forms other than physical currency. Finally, this process is risky as it can plunge the nation into utter chaos if is not handled with complete competence.