Devangshu Datta has a good run down of the basic facts of India’s demonetization of Rs 500 and Rs 1,000 notes:

About 85% of all currency in circulation has just been turned into coupons that can only be exchanged in specific places. These notes can be converted into currency again only with identity proofs (which hundreds of millions don’t have) and the additional hardship of standing in many queues for many hours. Over half of India’s population doesn’t have any sort of bank account at the moment and about 300 million don’t have basic ID such as Aadhaar either and hence, cannot access the banking system at all. About 130 million Indians have mobile wallets (about 25 million have credit cards) and there are maybe 550-600 million debit cards in circulation. So access to cash is very, very important for average Indians. …India is a cash economy. Well over 90% of all transactions are done in cash.

So how is India responding? Lineups at banks and ATMs are long. Tourists at the Taj Mahal have had minor troubles because ticket collectors aren’t accepting the demonetized notes. Demand for gold is up giving some jewelers a temporary albeit welcome windfall. Perhaps most telling is that at Zaveri Bazaar in Mumbai old notes were going at a 60% discount–that is a very heavy discount and indicates that the demonetization is, as I argued earlier, working as a tax on the black market. Other sources, however, indicate that discounts can be had for as low as 20%. Discounting, however, is illegal and the government is cracking down.

What, however, is the point? As Amit Varma argues:

…most truly rich people don’t keep their wealth in the form of cash, but in the form of real estate, gold, deposits in foreign bank accounts and other benaami investments. They will be largely unhurt…it is the poor who will be hurt the most by this.

And Ajay Shah notes:

Controlling corruption is not about blocking access to a non-traceable store of value. There will always be precious metals, US dollars, bitcoin, and jars of Tide…. Solving the problem of corruption requires deeper changes to institutions.

I see this as the main point of the exercise (quoting Datta):

The Income Tax and Excise Departments’ ability to gather data will increase exponentially. So will their discretionary powers, when they can query people who pay large sums in cash into their accounts.

That is not necessarily a bad thing. A key point is that only 1% of India’s population pays income tax–India would be a libertarian paradise if it had a libertarian government but it doesn’t. As a result, what low income tax payments mean is that India is forced to raise money in less efficient ways and to govern through regulation. Some of the only people who pay tax, for example, are those working in large multinational corporations but those are precisely the high-productivity sectors that need to grow.

India’s dilemma is that its high productivity sectors are taxed while its low-productivity sectors aren’t, so valuable resources are trapped in low productivity sectors. Modi knows this and if he is serious then his surprise demonetization will be followed by more efforts to bring India’s informal sector into the formal sector, leveling the playing field, and increasing total wealth.

Addendum: Mostly Economics has a discussion of two early demonetization in India, one in 1946 and one in 1978, both were focused on the larger bills unlike the current demonetization.