Legal tender and its withdrawal: demonetisation

Detail

1. What is legal tender?

• Legal tender is money that no citizen can refuse when someone uses it to settle a debt or a payment. The law gives it this status.
• Notes and coins are legal tender. Cheques are not.
• Fiat money backs legal tender. Fiat money has value because the government orders it, not because the paper or metal is worth that much.
• There are two kinds of legal tender:
• Unlimited legal tender: RBI banknotes. They must be accepted for any amount.
• Limited legal tender: coins. They must be accepted only up to a fixed sum.

2. Coins as limited legal tender (Coinage Act, 2011)

• The Government of India makes coins under the Coinage Act, 2011. The RBI only puts them into circulation. The RBI itself issues banknotes.
• Legal-tender limits for coins (a coin must be undamaged and must not have lost weight beyond the allowed limit) [6]:

Coin	Must be accepted for sums up to
₹1 and above	₹1,000
50 paise (half-rupee)	₹10
Any smaller coin	₹1 [6]

• Coins of 25 paise and below stopped being legal tender from 30 June 2011 [7]. This shows that coins can also be demonetised.
• Coins now in circulation: 50 paise, ₹1, ₹2, ₹5, ₹10 and ₹20 [6][7].
• Worked example:
• A shopkeeper's bill is ₹1,500. You offer 150 coins of ₹10.
• The shopkeeper must accept coins only up to ₹1,000. They can legally refuse the rest.
• If you pay ₹1,500 in ₹500 notes, the shopkeeper cannot refuse, because notes are unlimited legal tender.

3. Money, but not legal tender: demand deposits

• Demand deposits are savings or current account balances that you can withdraw at any time, for example by cheque.
• They are counted as money because they are widely accepted and are part of M1 (currency with the public + demand deposits + other deposits with the RBI).
• But a cheque drawn on a demand deposit can be refused. So demand deposits are money but not legal tender.
• UPI payments and card payments move demand deposits. So they are also not legal tender. A seller may refuse them, but cannot legally refuse RBI notes.

4. Demonetisation: meaning and legal route

• Demonetisation means taking away legal-tender status from a series of currency notes. After that, the notes are just paper.
• Legal route:
• The RBI's Central Board recommends it.
• The Government of India issues a notification in the Gazette under RBI Act, 1934, s.26(2).

• The notified series then stops being legal tender.

• Demonetisation is different from withdrawal from circulation:

• Demonetisation: the note is no longer legal tender (2016 ₹500/₹1000).
• Withdrawal from circulation: the RBI stops issuing the note and takes it back, but it remains legal tender (₹2000 in 2023).

5. Indian episodes

Year	Notes withdrawn	Legal route
January 1946	₹500, ₹1000, ₹10,000	Ordinance
January 1978	₹1000, ₹5000, ₹10,000	High Denomination Bank Notes (Demonetisation) Act, 1978
8 November 2016	Old ₹500 and ₹1000 ("Specified Bank Notes", SBNs)	Notification under RBI Act s.26(2)
30 June 2011 (coins)	25 paise and below	Ceased to be legal tender [7]

• In 1946 and 1978, only high-value notes were cancelled. Ordinary people rarely held them, so the impact was small.
• The 2016 move was different. It cancelled the most commonly used notes.

6. 2016 demonetisation: the details (Class 12, Box 3.2)

• Date: announced on the evening of 8 November 2016.
• Scale: the SBNs were worth about ₹15.4 lakh crore, which was 86.9% of the value of all notes in circulation [2]. (NCERT: about 86%.)
• Aims:
• Fight corruption.
• Fight black money, meaning income hidden from tax.
• Stop terror financing.

• Remove fake currency.

• New notes: new ₹500 and ₹2000 notes were launched.

• The ₹2000 note was introduced mainly to refill the currency supply quickly [4].

• Deposit windows:

• Deposit in a bank account without any declaration until 31 December 2016. (PRS gives the cut-off date as 30 December 2016 [5].)

• Deposit with the RBI, with a declaration, until 31 March 2017. This grace window was mainly for Indian citizens who were abroad between 9 November and 30 December 2016 [5].

• Exchange limit: ₹4,000 of old notes per person per day.

• Exemptions: old notes were accepted until 12 December 2016 at:
• petrol pumps,
• government hospitals,
• and for government dues such as taxes and power bills.

7. The result: how much came back?

• About ₹15.31 lakh crore of the ₹15.41 lakh crore of SBNs came back to the RBI. That is about 99.3% (RBI Annual Report 2017-18) [2][3].
• Worked example: return ratio
• Formula: Return ratio = (SBNs returned ÷ SBNs in circulation) × 100
• = (15.31 ÷ 15.41) × 100 ≈ 99.3%

• Not returned ≈ 15.41 − 15.31 = ₹0.10 lakh crore (about ₹10,000 crore), which is only about 0.7%.

• What this means:

• Very little black money was destroyed as cash.
• Most black money is kept as gold, real estate or foreign assets, not as cash.
• Most cash that was held illegally still got into the banks through deposits. It then came under scrutiny from the tax department.

8. Specified Bank Notes (Cessation of Liabilities) Act, 2017

• Timeline:
• An Ordinance was issued on 30 December 2016.
• The Bill was introduced in the Lok Sabha on 3 February 2017 [5].

• It later became the Act of 2017 [5][8].

• Main provision: from 31 December 2016, the SBNs are no longer a liability of the RBI [5].

• Every note is a liability of the RBI. That is why the note carries the words "I promise to pay the bearer…".

• The Act ended this promise for the old notes.

• Holding limits [5]:

• Up to 10 old notes in total (any mix of the two denominations).

• Up to 25 notes for study, research or numismatics (coin and note collecting).

• Penalties [5][8]:

• Holding more than the limit: a fine of ₹10,000 or five times the face value, whichever is higher.
• False declaration during the grace period: a fine of ₹50,000 or five times the face value, whichever is higher.
• The fines are imposed by a Magistrate or Metropolitan Magistrate [5].

9. The Supreme Court verdict

• In January 2023, the Supreme Court upheld the 2016 decision by a 4:1 majority in Vivek Narayan Sharma v. Union of India.
• The Court held that the move followed the s.26(2) route and was not invalid.

10. Class 12's balance sheet of 2016

• Costs:
• Long queues at banks and ATMs.

• A cash crunch (too little cash) that hurt economic activity for a while, especially in the cash-heavy informal sector.

• Gains claimed:

• Better tax compliance and a wider tax net:
  • Large cash deposits left a record.
  • The tax department could match these deposits with income returns.
  • More people started filing returns.
• Savings entered the formal financial system:
  • Bank deposits rose.
  • Banks had more money to lend.
  • Lending rates could fall.
• A signal that tax evasion will not be tolerated.

• A shift from cash to electronic payments.

• Class 10's teacher note says the same thing. After 2016, people were pushed towards cheques, debit and credit cards, POS machines (point-of-sale card machines in shops) and UPI QR codes.

11. Contrast: the ₹2000 note (2023)

• Background:
• The note was introduced in November 2016 to meet the economy's need for currency quickly.

• With that aim met, the RBI stopped printing it in 2018-19 [4].

• 19 May 2023: the RBI announced that the note would be withdrawn from circulation.

• It continues to be legal tender [3][4].

• So this is a clean-note policy step, meaning the RBI replaces old or unneeded notes with fresh ones. It is not a demonetisation.

• Status:

• ₹3.56 lakh crore was in circulation on 19 May 2023.
• This fell to ₹5,743 crore by 29 November 2025.

• So 98.39% has returned [3].

• Worked example:

• Formula: % returned = (1 − 5,743 ÷ 3,56,000) × 100
• = (1 − 0.0161) × 100 ≈ 98.39%

12. Links to other notes

• The effects of demonetisation on liquidity (the amount of ready cash in the system) → banking-monetary-policy.
• The digital payments push → payment-systems-digital-finance.

Prelims Hooks

• Legal tender is money that cannot be refused in settling a payment. Cheques, demand deposits and UPI balances are money but NOT legal tender.
• RBI banknotes are unlimited legal tender. Coins are limited legal tender under the Coinage Act, 2011:
• ₹1 and above: up to ₹1,000.

• 50 paise: up to ₹10.

• Coins are made by the Government of India, while banknotes are issued by the RBI.

• Demonetisation needs a Government of India notification under RBI Act s.26(2), on the RBI Central Board's recommendation.
• 1978 demonetisation came through an Act. 1946 came through an Ordinance. 2016 came through a notification.
• 2016: the SBNs were 86.9% of the value of notes in circulation, and 99.3% of them came back to the RBI (RBI AR 2017-18) [2].
• SBN (Cessation of Liabilities) Act, 2017:
• The RBI's liability ended from 31 December 2016.

• Holding more than 10 notes (or 25 for research or numismatics) is an offence [5].

• Trap: the ₹2000 note (May 2023) was withdrawn but is STILL legal tender. So it was not demonetised [3].

• Trap: coins of 25 paise and below were demonetised on 30 June 2011 [7].
• Vivek Narayan Sharma v. Union of India (January 2023): the Supreme Court upheld the 2016 demonetisation by 4:1.

Mains Points

• Aims vs outcome:
• The 2016 aim was to destroy black money.
• But 99.3% of the SBNs returned [2].

• This shows that most black money is not held as cash. So attacking assets such as benami property and real estate, and using tax data analytics, may work better than cancelling notes.

• Short-term costs vs long-term formalisation:

• Short-term costs: a cash crunch, lost jobs and output in the informal sector, and queues.
• Longer-term gains: a wider tax base, more financial savings and a jump in digital payments (UPI, POS).

• Useful for GS-III: inclusive growth and the informal economy.

• Institutional design:

• s.26(2) gives the executive strong power over currency, with only an RBI recommendation as a check.

• Link this to RBI autonomy, judicial review (4:1 verdict, 2023) and the use of Ordinances vs Acts (1946/1978/2016-17) in GS-II.

• A calibrated tool:

• The 2023 ₹2000 withdrawal kept legal-tender status and still saw 98.39% of the notes return with no disruption [3].
• This shows a gentler, clean-note-policy way to manage currency, instead of sudden demonetisation.