17 April 2024

CEPR: Managing the transition to central bank digital currency

Using a two-country model with financial frictions and under plausible assumptions for demand for central bank digital currency, the transition has volatility in the digital currency, cash, and deposits, leading to volatility in loan rates, investment, and consumption.

Most studies on central bank digital currencies focus on the effects after they become well established. This column analyses the macroeconomic effects in the transition to the new equilibrium. Using a two-country model with financial frictions, it shows that, under plausible assumptions for demand for central bank digital currency, the transition is characterised by volatility in the digital currency, cash, and deposits, leading to volatility in loan rates, investment, and consumption. Binding caps on holdings of the digital currency during the transition period are shown to be most effective in reducing disintermediation and output losses and in minimising international spillovers. 

A large academic literature – summarised in Ferrari Minesso et al. (2021), Niepelt (2021), and Panetta et al. (2022) – has developed and examined various potential effects of central bank digital currencies (CBDCs) on banks, the financial sector more broadly, and the rest of the economy, as well as on international spillovers. These papers have studied how shocks propagate differently through the economy once CBDCs are available, that is, around the new equilibrium with CBDC well established as a monetary instrument.

In a recent study (Assenmacher et al. 2024), we look at the issue from a different angle. We study the macroeconomic effects of CBDC in the transition to the new equilibrium – that is from the moment of initial launch up to the longer run before the CBDC is well established as a monetary instrument. We pay particular attention to policies that can help balance trade-offs in the transition phase. On the one hand, risks to macroeconomic and financial stability from excess demand for CBDC can arise. On the other hand, welfare losses may materialise when CBDC demand is overly constrained and the resulting menu of monetary instruments available to households overly reduced. ¹

We develop a two-country model with financial frictions to study the transition from a steady-state without CBDC to one in which the home country issues a CBDC. There are two symmetric economies (home and foreign), which trade goods and financial assets under incomplete financial markets. In each country, consumers supply labour to firms, save, and consume final aggregate goods. They also need liquid assets to purchase final goods and can invest in three financial assets: bonds, deposits, and money, which in our setup means cash. Money can be used for payment, is not remunerated, and is subject to linearly increasing storage costs. Bonds, which are the only asset traded internationally, are remunerated but cannot be used for payment. Deposits are remunerated and can be used for payment, though they may not provide the same liquidity services as cash. Put differently, households have specific preferences over payment instruments, which are imperfect substitutes. Importantly, banks hold market power in the deposit market (see Drechsler et al. 2017, Andolfatto 2021). They can extract a surplus from deposit contracts, i.e. utility that households derive from liquidity services provided by deposits. As a result, deposits are remunerated below their marginal return for banks and the risk-free rate. Households accept such a contract in equilibrium because deposits provide valuable liquidity services.

The financial sector is populated by finitely lived banks that combine net worth and deposits to finance loans to firms. We assume that there is a financial friction like the ‘financial accelerator’ mechanism of Bernanke et al. (1999), which implies that bank credit plays a key role in firms’ financing. This mechanism also introduces frictions in the credit market, which only slowly adjusts to shocks. The economy’s production sector is populated by three different types of firms: capital good producers, intermediate good producers, and retailers.

Importantly, we assume that – in addition to cash – the home country can issue a central bank digital currency (CBDC). The CBDC is a liability of the central bank that is directly accessible to households and can be used for payment. Moreover, the CBDC can be traded across countries subject to certain limits. In the baseline configuration, it is not remunerated. It is a digital payment instrument – a digital version of a banknote – and is not subject to storage costs, unlike cash. ²   CBDC provides variety to the menu of monetary instruments available, which households value – their marginal utility decreases in the amount of each instrument held. Moreover, as CBDC adds an alternative payment instrument, households’ budget constraints become less binding, thereby lowering the rents banks can extract from deposits. In the absence of adjustment of the terms of deposit contracts by banks, deposits would flow out from the banking system, resulting in bank disintermediation....

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