Monetary Policy, Liquidity Shock and Bank lending: The Case of Currency Demonetization in India

Gyasuddin Ansari MD () and Rudra Sensarma
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Gyasuddin Ansari MD: Indian Institute of Management Kashipur

No 575, Working papers from Indian Institute of Management Kozhikode

Abstract: In this paper, we examine the effect of a change in bank deposits on banks’ lending and investment behaviour. To identify the change in deposits, we study a positive liquidity shock i.e., currency demonetization in India in November 2016. We exploit the demonetization effect on different types of banks’ deposits (savings bank deposits and demand deposits) to find that the increase in deposits had a negative effect on bank lending. However, banks’ balances with the central bank went up with an increase in deposits induced by demonetization. When we analyse the one year lagged effect of deposits on bank lending, we find a positive impact suggesting a long run increase in lending due to demonetization. Finally, we investigate the implications for monetary policy transmission and find that the increase in deposits due to a liquidity shock weakened the monetary policy transmission to bank lending in the long-run.

Keywords: Demonetization; Monetary Policy Transmission; Deposits; Liquidity; Bank Lending. (search for similar items in EconPapers)
Pages: 36 pages
Date: 2023-03
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