This will also increase the lending activity because banks have a CRR (cash reserve ratio) to maintain and with more deposits they can do more lending.Credit (loans) will become easier and interest rates may come down. More loans given out increases broad money supply and creates inflation. But this will happen slowly, not over-night.
What will happen over-night is heavy deflation.Because people who have illegally earned this money may be afraid to deposit it in a bank. There are people with crores of cash, black money, earned through illegal ways, such as corruption, smuggling etc.Some of these guys will try to find this money into a bank, but they have to declare it as income and pay taxes on it. Then the question arises – how did they make this income in the first place. Most of these guys will chicken out, count their blessings and just waste the money they have stashed somewhere in Rs.500 and Rs.1000 notes.
This will reduce the total currency circulation in the economy – leading to deflation. Deflation increases the value of money that we have because the total money supply goes down but the commodities and things available in the market have not gone down.[Example] If there are 100 widgets and 100 coins, each widget’s value would be Rs.1. If there are 100 widgets and only 50 coins, each widget would cost Rs.0.50 only. Which means with each coin, you can buy 2 widgets.The inflation and deflation will balance out each other on some level. But it is going to take some time for the inflation to happen because lending activities do not happen over night.
Deflation will happen first, for the next 6 months to 1 year. Gold prices will drop, stocks & commodities will drop. Everyone will get excited and congratulate the government for making this move.Then slowly, as lending activity goes up, the broad money supply will go up and prices of all things would go up, slowly and steadily.
Now no one can predict the extent of the deflation and inflation. In an ideal world, if 100% of the people who have Rs.500 and Rs.1000 notes have it as white money, then we would see only inflation. If a lot of these are black money and if many people decide to waste the money instead of depositing it, then we will have deflation in the short term.
If you see heavy deflation and heavy drop in prices, then it means that India has a lot of corrupt people who earned money in illegal ways, too afraid to deposit the money in a bank! And my gut feeling says that we would see heavy deflation in the next 6 months. If you bet on this, then buy gold, stocks of asset-heavy companies.