CBDC and Monetary Policy

Highlights

  • An interest-bearing and universally accessible central bank digital currency (CBDC) could be a versatile instrument that would, in theory, improve monetary policy by allowing non-linear transfers and more direct implementation and transmission. These expected benefits, however, might be small or are unlikely to be realized in practice.
  • One benefit of a CBDC could be to allow monetary policy to break below the effective lower bound (ELB). This would require removing cash or restricting cash holdings (e.g., removing large-denomination notes). But this alone would not be a sufficient condition to potentially realize the benefit of breaking below the ELB during downturns.
  • A second potential benefit of issuing a CBDC could be to help maintain the effectiveness of monetary policy by reducing the incentives to adopt alternative means of payment. The widespread adoption of competing means of payment not denominated in domestic currency (including foreign currency and cryptocurrencies) could imperil the central bank’s ability to achieve its current monetary policy objectives. However, this scenario is unlikely to occur in Canada.
  • The caveats around the potential monetary policy benefits of a CBDC stem from knowledge gaps and implementation challenges. These include:
    • questions about the feasibility and consequences of removing cash
    • the need for better empirical estimates of the benefits of breaking below the ELB
    • the need to understand the potential effects on the current (or new) transmission channels of monetary policy

Introduction

Central banks and academics are discussing the possibility of central bank issuance of a digital currency. Many arguments exist for and against issuing a CBDC. This note discusses the two most important arguments from the perspective of the monetary policy objective of price stability. In the next two sections, we state each argument and discuss the corresponding caveats and implications for the form of a CBDC. Throughout this note, we assume that the CBDC is universally accessible, but we impose no assumptions on transaction limits.

A CBDC could improve the effectiveness of monetary policy—proactive argument

During recessions, central banks normally reduce short-term interest rates to stimulate aggregate investment and consumption. When interest rates are close to the ELB, this policy is less effective because individuals can hold cash to avoid negative interest rates. This problem could be solved by restricting cash withdrawals and deposits, eliminating large-denomination notes or eliminating cash altogether. However, it may be more desirable to replace cash with an interest-bearing CBDC if, from a public policy perspective, there is a preference for a government-issued retail means of payment.

An interest-bearing CBDC could reduce the opportunity cost agents bear when holding means of payment. It would do this by allowing more flexible transfer schemes, where interest rates can be conditional on balances—for example, if agents held high money balances, they would be subject to a different interest rate than if they held low money balances. This could induce agents to maintain an efficient level of liquidity.1

A CBDC could influence the market for deposits. If CBDC and bank deposits were close substitutes, then a CBDC with a non-zero interest rate could provide a floor for deposit rates. Even if the CBDC were not widely used, the CBDC rate could influence the deposit market by offering depositors an outside option, making the deposit market more competitive.2 Interest rates on CBDC deposits could be an additional monetary policy tool that would need to be set consistently with other policy rates. In this way, deposit rates would be more closely linked to the CBDC and other policy rates, improving the transmission of monetary policy.

To realize these benefits, a CBDC would have to be designed to bear interest, both negative and positive. An account-based system may be preferable to a token-based system. This is because an account-based system allows for the policy interest rate to be time-varying and contingent on the balance held.

Caveats

There are few quantitative estimates of the benefits of breaking below the ELB. Even if the benefits were large, other policies exist that could help break below the ELB without introducing a CBDC. One suggestion is to use a time-varying deposit fee on physical currency between private banks and the central bank (Agarwal and Kimball 2015). This would allow the central bank to create an exchange rate between physical currency and bank deposits, which would help implement a negative interest rate policy.

Likewise, estimates of the long-run benefits of a more flexible monetary policy are limited, and they range widely. We are aware of only two papers that study this issue:

  • Davoodalhosseini (2018), in his benchmark model, estimates the benefits of a CBDC to be around 0.16 percent of total consumption. This rises to 0.64 percent of total consumption in various scenarios where he considers different advantages cash has over a CBDC (e.g., anonymity) and the relative size of large and small transactions.
  • Barrdear and Kumhof (2016) estimate that introducing a CBDC would lead to an increase of 3 percent in gross domestic product. They obtain this higher estimate because the introduction of a CBDC in their model represents a 30 percent increase of aggregate liquidity, a form of quantitative easing. This result relies heavily on the logic that a CBDC reduces the defaultable government debt in the economy by increasing the debt of the central bank, which reduces real interest rates. However, real interest rates may depend on the consolidated debt of the government and the central bank, not only the government’s debt.3

Removing cash from the economy or restricting its holdings could have several immediate implications:

  • Some groups in society could be severely or disproportionately affected depending on their geographic location, level of income or other demographic characteristics, like age and disabilities.
  • Removing cash could lessen the resilience of the payments ecosystem by increasing cyber security risks and the system’s dependence on other infrastructures (e.g., the internet, telecommunications and the electric grid).
  • Removing cash could incite resistance from the public.

Further, “eliminating [cash] a core symbol of the monetary regime could disrupt common social conventions for using money, possibly in unexpected ways” (Rogoff 2017).

An additional challenge is that removing cash or restricting its holdings would be a necessary but not sufficient condition to potentially realize the benefit of breaking below the ELB during downturns. In fact, individuals would likely seek alternatives to a CBDC precisely during periods when central banks are pursuing negative interest rates. Alternatives could include foreign currencies or private cryptocurrencies, increasing the risk of their widespread adoption. This would ultimately reduce the effectiveness of monetary policy because these alternatives are not denominated in the domestic unit of account.

Lastly and importantly, little is known about how a CBDC would affect the current channels of transmission of monetary policy or whether new ones would emerge. For example, interest on a CBDC may be a more direct policy instrument because it does not need to be passed through to the economy by the financial sector. Further analysis is needed.4

A CBDC could help maintain the effectiveness of monetary policy—defensive argument

The widespread adoption of alternative means of payment not denominated in the domestic currency would weaken the transmission of monetary policy because the central bank would have influence on a smaller portion of the economy. This consideration is particularly important if the suppliers of the alternative means of payment have interests that are not in line with the objectives of the central bank (Davoodalhosseini and Rivadeneyra 2018).5 In such a case, the central bank may be forced to respond to the policy of the supplier of alternative means of payment. This could increase the constraints and reduce the effectiveness of central bank monetary policy (Zhu and Hendry 2019). A CBDC, if it is appropriately designed, could counter the adoption of alternative means of payment.

The wide adoption of new means of payment denominated in the domestic currency would not threaten the central bank’s ability to implement monetary policy—even if this adoption were accompanied by a decline in the demand for cash. In fact, currently:

  • most money in the economy is “inside money” in the form of bank liabilities,6
  • cash is a small fraction of balances, and
  • most payments are done through the electronic transfer of inside money using central bank money (reserves) as a settlement asset.

With or without cash in circulation, monetary policy can be implemented as long as payment providers demand the settlement asset controlled by the central bank.

Caveats

It is unlikely that a scenario of widespread adoption of an alternative means of payment not denominated in the domestic currency will materialize in the near future. For it to happen, there would have to be a growing demand for certain features in means of payment that traditional instruments cannot provide. But at this moment, it is unclear what these features are or whether demand would be strong enough to drive agents to adopt an alternative means of payment not denominated in the domestic currency. One potential indicator of this scenario would be if commercial banks were to start taking deposits in large scale of such means of payment.

Concluding remarks

Issuing a CBDC, in practice, would be unlikely to help the central bank improve the effectiveness of monetary policy. One difficulty is that in order for a central bank to realize any potential monetary policy benefits, the CBDC would have to be able to bear interest (positive or negative) and cash would have to be removed or have its use restricted. In addition, the magnitude of these benefits, which are obtained from breaking the ELB in the short run and reducing the opportunity cost of holding liquidity in the long run, is still unclear and needs to be further explored. Finally, issuing a CBDC may not be the only way for a central bank to realize these benefits: for example, a central bank may be able to break the ELB under the current monetary system by charging a time-varying fee on cash deposits.

  1. 1. See Davoodalhosseini (2018) for further details.[]
  2. 2. Recently, some central banks have allowed a wider set of financial institutions to participate in reverse repos. This effectively extends access to their balance sheets and provides an outside option that enforces the floor of the monetary policy corridor. A CBDC plays a similar role to a reverse repo in the retail deposit market.[]
  3. 3. See Gale and Orszag (2004), Engen and Hubbard (2004) and Laubach (2009).[]
  4. 4. Recent research sheds light on these questions: see, e.g., Brunnermeier and Niepelt (2019), Meaning et al. (2019) and Kumhof and Noone (2019).[]
  5. 5. It has also been argued that declining demand for domestic currency reduces the central bank’s ability to raise seigniorage income. This would also reduce the size of the balance sheet, limiting the central bank’s ability to implement monetary policies; and it could jeopardize its independence. This may not be a strong argument for issuing a CBDC, as central banks have other sources of funding. Therefore, we don’t consider it in this note.[]
  6. 6. Inside money is defined by Lagos (2006) as “an asset backed by any form of private credit that circulates as a medium of exchange”; this contrasts with “outside money,” which he defines as “money that is either of a fiat nature or backed by some asset that is not in zero net supply within the private sector.”[]

References

  1. Agarwal, R. and M. Kimball. 2015. “Breaking Through the Zero Lower Bound.” International Monetary Fund Working Paper No. 15-224.
  2. Barrdear, J. and M. Kumhof. 2016. “The Macroeconomics of Central Bank Issued Digital Currencies.” Bank of England Staff Working Paper No. 605.
  3. Brunnermeier, M. K. and D. Niepelt. 2019. "On the Equivalence of Private and Public Money." Journal of Monetary Economics 106: 27–41.
  4. Chiu, J., M. Davoodalhosseini, J. Jiang and Y. Zhu. 2019. “Central Bank Digital Currency and Banking.” Bank of Canada Staff Working Paper No. 2019-20.
  5. Davoodalhosseini, M. 2018. “Central Bank Digital Currency and Monetary Policy.” Bank of Canada Staff Working Paper No. 2018-36.
  6. Davoodalhosseini, M. and F. Rivadeneyra. 2018. “A Policy Framework for E-Money: A Report on Bank of Canada Research.” Bank of Canada Staff Discussion Paper No. 2018-5.
  7. Engen, E. M. and R. G. Hubbard. 2004. “Federal Government Debt and Interest Rates.” NBER Macroeconomics Annual 19: 83–138.
  8. Gale, W. and P. Orszag. 2004. “Budget Deficits, National Saving, and Interest Rates.” Brookings Papers on Economic Activity, no. 2; 101–187.
  9. Kumhof, M. and C. Noone. 2019. “Central Bank Digital Currencies—Design Principles and Balance Sheet Implications.” Bank of England Staff Working Paper No. 725.
  10. Lagos, R. 2006. “Inside and Outside Money.” Federal Reserve Bank of Minneapolis Research Department Staff Report No. 374.
  11. Laubach, T. 2009. “New Evidence on the Interest Rate Effects of Budget Deficits and Debt.” Journal of the European Economic Association 7 (4): 858–885.
  12. Meaning, J., B. Dyson, J. Barker and E. Clayton. 2019. “Broadening Narrow Money: Monetary Policy with a Central Bank Digital Currency.” Bank of England Staff Working Paper No. 724.
  13. Rogoff, K. S. 2017. The Curse of Cash: How Large-Denomination Bills Aid Crime and Tax Evasion and Constrain Monetary Policy. Princeton, NJ: Princeton University Press.
  14. Zhu, Y. and S. Hendry. 2019. “A Framework for Analyzing Monetary Policy in an Economy with E-money.” Bank of Canada Staff Working Paper No. 2019-1.

Avis d’exonération de responsabilité

Les notes analytiques du personnel de la Banque du Canada sont de brefs articles qui portent sur des sujets liés à la situation économique et financière du moment. Rédigées en toute indépendance du Conseil de direction, elles peuvent étayer ou remettre en question les orientations et idées établies. Les opinions exprimées dans le présent document sont celles des auteurs uniquement. Par conséquent, elles ne traduisent pas forcément le point de vue officiel de la Banque du Canada et n’engagent aucunement cette dernière.