Central bank digital currency and the future of monetary policy

Michael Bordo, Andrew Levin 23 September 2017

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In third-century Rome, Julius Paulus Prudentissimus, chief legal advisor to Emperor Severus Alexander, described the fundamental rationale for a government-issued currency using terms that remain familiar to modern monetary economists. It was, he wrote, a unit of account for the pricing of goods and services, a method of storing value, and a medium of exchange that facilitated economic and financial transactions (Watson 2010). Paulus had recognised that the utility of currency depended on its nominal quantity, not on its material substance. That is, the efficacy of a currency hinges on public confidence in the authorities’ management of the monetary system.

Nearly 2,000 years later, as electronic devices and high-speed networks have become practically ubiquitous, central banks including the ECB (Mersch 2017) Norges Bank (Nicolaisen 2017) and the Bank of Canada (Fung and Halaburda 2016) are exploring the possibility of establishing sovereign digital currencies. The Sveriges Riksbank has an accelerated timeframe for deciding whether to launch a digital currency (Skingsley 2016). The People’s Bank of China is experimenting with technical specifications (Yifei 2016). The Bank of England has initiated a multi-year investigation (Broadbent 2016).

Just like paper currency and coins, central bank digital currency (CBDC) would be fixed in nominal terms, universally accessible, and valid as legal tender for all public and private transactions. Consequently, CBDC is essentially different from the virtual currencies created by private entities such as bitcoin, ethereum, and ripple, whose market prices have fluctuated sharply in recent years (Scorer 2017).

The design of central bank digital currency

Our recent work attempts to formulate a set of design principles, rather than a technical blueprint, for CBDC (Bordo and Levin 2017). In particular, we consider five questions:

  • Should CBDC payments involve transfers between accounts held at the central bank, or digital tokens that can be transferred directly from payer to payee?
  • Should cash be abolished, or should the central bank establish a schedule of fees for transferring funds between CBDC and paper currency?
  • Should CBDC be interest-bearing, or indexed to an aggregate price index, rather than having a constant nominal value like cash and coins?
  • What would the implications of CBDC be for the central bank’s monetary policy strategy and operating procedures?
  • How would CBDC affect the interactions between the central bank and the fiscal authorities?

When considering these issues, we assume that the central bank’s objective is to maximise the effectiveness of CBDC in fulfilling the basic functions of any public currency – its efficiency as a medium of exchange, its security as a store of value, and its stability as the unit of account for economic and financial transactions. Using these criteria, we identify the characteristics of a well-designed CBDC:

  • Practically costless medium of exchange. If CBDC were account-based, the accounts could be held directly at the central bank itself or made available via public-private partnerships with commercial banks.
  • Secure store of value. Interest-bearing CBDC could have a rate of return in line with risk-free assets such as short-term government securities. The CBDC interest rate would serve as the main tool for conducting monetary policy.
  • Gradual obsolescence of paper currency. CBDC can be made widely available to the public, with a graduated schedule of fees on transfers between cash and CBDC. Consequently, adjustments to the CBDC interest rate would not be constrained by any effective lower bound.
  • True price stability. A monetary policy framework is possible in which the real value of CBDC would remain stable over time in terms of a broad consumer price index. This framework would encourage the systematic and transparent conduct of monetary policy.

Our analysis draws on a long strand of literature in monetary economics. The quest for a stable unit of account was pursued by luminaries like Jevons (1875), Marshall (1877), Wicksell (1898), Fisher (1913), Buchanan (1962), and Hayek (1978). The rationale for an efficient medium of exchange was highlighted by Friedman (1960), who argued that government-issued money should bear the same rate of return as other risk-free assets (Friedman and Schwartz 1986 also discussed the fundamental rationale for a government-issued currency).

These two goals – that is, a stable unit of account and an efficient medium of exchange – seemed to be irreconcilable due to the impracticalities of paying interest on paper currency, and hence Friedman advocated a steady deflation rather than price stability. But the achievement of both goals has now become feasible using a well-designed CBDC.

Advantages of central bank digital currency

As a practically costless medium of exchange, CBDC would enhance the efficiency of the payments system. For example, a recent IMF study pointed out that the introduction of CBDC would facilitate more rapid and secure settlement of cross-border financial transactions (He et al. 2017). CBDC would be particularly beneficial for low-income households, which tend to rely heavily on cash, and for small businesses, which incur high costs for handling cash or high interchange fees when they take payments using debit and credit cards. At a macroeconomic level, researchers at the Bank of England have estimated that the productivity gains from adopting CBDC would be similar to those of a substantial reduction in distortionary taxes (Barrdear and Kumhof 2016).

The interest-bearing design of CBDC, and the obsolescence of paper currency, would also contribute to greater macroeconomic stability, because interest rate adjustments would have the advantage of no longer being constrained by an effective lower bound in response to severe adverse shocks.

The merits of removing the zero lower bound have long been considered for existing currency systems, by Goodfriend (2000, 2016), Buiter (2009), Agarwal and Kimball (2015), and Pfister and Valla (2017) among others. The lower bound has been a key reason why many central banks currently aim at positive inflation rates of 2% or more, whereas CBDC will essentially eliminate the need to maintain this inflation buffer, or to deploy alternative monetary policy tools such as quantitative easing or credit subsidies.

Moreover, in the event of a severe economic downturn, CBDC would facilitate the provision of money-financed fiscal stimulus. Dyson and Hodgson (2017) point out that, in a downturn, funds could be deposited directly into the CBDC accounts of low-income households, cushioning their purchasing power from the effects of the downturn as well as from the temporarily negative level of the CBDC interest rate. Indeed, Friedman (1948) highlighted the complementarities between monetary and fiscal expansion under such circumstances.

CBDC is a natural extension of current trends in monetary operations. For example, most central banks already pay interest on the reserves of commercial banks, which are a large portion of the total monetary base. The Federal Reserve has expanded its capacity to pay interest to an even wider range of counterparties by borrowing funds in the US Treasury repo market. Moreover, the Federal Reserve Banks now maintain segregated deposit accounts for systemically important financial market utilities, so that the customers of those utilities know that their funds are secure, liquid, and interest-bearing. For example, segregated reserve accounts at the Federal Reserve Bank of Chicago have been created to hold the funds of customers of the Chicago Mercantile Exchange, and the initial margin accounts of customers of ICE Clear Credit.

Aiming monetary policy at true price stability would be substantively different from the current practice of inflation-forecast targeting. As noted above, most central banks have a 2% or higher inflation target, and place no weight on previous deviations of inflation from target, so that the aggregate price level follows a random walk with upward drift.

In contrast, under a price-level target, consumer prices would still exhibit transitory fluctuations, but monetary policy will ensure that the aggregate price level would return to its target over time. Households and businesses would be able to plan with confidence that the cost of a representative basket of consumer items (as measured in terms of CBDC) would be stable over the medium run and roughly constant at planning horizons of 5, 10, 20, and even 50 years into the future. This stability could be particularly beneficial for low-income households and small businesses, which typically have little or no access to sophisticated financial planning advice or complex financial instruments to insure against risks.

The widespread use of CBDC, and the obsolescence of paper currency, would discourage tax evasion, money laundering, and other illegal activities that are made easier by paper currency, especially, large-denomination bills (Rogoff 2016). This benefit is important in advanced economies, but even more pertinent for developing economies where a large fraction of economic activity is conducted using cash, and incidence of tax evasion is very high. The feasibility of CBDC has been demonstrated in Ecuador, where CBDC has become widely available through a simple and secure platform (a two-step verification with mobile phones and text messages).1 Likewise, in Kenya’s government has been a pioneer in establishing a public-private partnership for providing low-cost digital payments through Safaricom, which currently provides digital payments (using the M-Pesa platform) to about 25 million Kenyan customers. Its two largest shareholders are
Vodafone (50%) and the Kenya Treasury Department (25%).

The risk of central bank passivity

Given the rapid pace of innovations in payments technology and the proliferation of virtual currencies such as bitcoin and ethereum, it might not be prudent for central banks to be passive in their approach to CBDC. If the central bank does not produce any form of digital currency, there is a risk that it loses monetary control, with greater potential for severe economic downturns. With this in mind, central banks are moving expeditiously when they consider the adoption of CBDC.

References

Agarwal, R and M Kimball (2015), “Breaking Through the Zero Lower Bound”, International Monetary Fund Working Paper 15-224.

Barrdear, J and M Kumhof (2016), “The Macroeconomics of Central Bank Issued Digital Currencies”, Bank of England Staff Working Paper No. 605..

Bordo, M and A Levin (2017), “Central Bank Digital Currency and the Future of Monetary Policy”, NBER Working Paper No. 23711.

Broadbent, B (2016), “Central Banks and Digital Currencies.” Speech to London School of Economics, 2 March.

Buchanan, J (1962), “Predictability: The Criterion of Monetary Constitutions”, In: Leland Yaeger, In Search of a Monetary Constitution. Harvard University Press: 155-183.

Buiter, W (2009), “Negative Nominal Interest Rates: Three Ways to Overcome the Zero Lower Bound”, NBER Working Paper No. 15118.

Dyson, B and G Hodgson (2017), “Digital Cash: Why Central Banks Should Start Issuing Electronic Money”, Positive Money.

Fisher, I (1913), “A Compensated Dollar”, Quarterly Journal of Economics, 27: 213–235, 385-397.

Friedman, M (1948), “A Monetary and Fiscal Framework for Economic Stability”, American Economic Review, 38: 245-264.

Friedman, M (1960), A Program for Monetary Stability, New York: Fordham Press.

Friedman, M (1984), “Financial Futures Markets and Tabular Standards”, Journal of Political Economy, 92: 165-167.

Friedman, M and A Schwartz (1986), “Has Government Any Role in Money?” In: Anna Schwartz, ed., Money in Historical Perspective, Chicago, IL: University of Chicago Press: 289-314.

Fung, B and H Halaburda (2016), “Central Bank Digital Currencies: A Framework for Assessing Why and How”, Bank of Canada Staff Discussion Paper 2016-22.

Goodfriend, M (2000), “Overcoming the Zero Bound on Interest Rate Policy”, Journal of Money, Credit, and Banking, 32: 1007-1035.

Goodfriend, M (2016), “The Case for Unencumbering Interest Rate Policy at the Zero Lower Bound”, Economic Review, Federal Reserve Bank of Kansas City.

Hayek, F (1978), Denationalisation of Money—The Argument Refined: An Analysis of the Theory and Practice of Concurrent Currencies (2nd edition), London: Institute of Economic Affairs.

He, D, R Leckow, V Haksar, T Mancini, N Jenkinson, M Kashima, T Khiaonarong, C Rochon, and H Tourpe (2017), “Fintech and Financial Services: Initial Considerations”, International Monetary Fund Staff Discussion Note 17/05.

Jevons, W (1875), “A Tabular Standard of Value.” In: Money and the Mechanism of Exchange, Chapter 25.

Marshall, A (1887), “Remedies for Fluctuations of General Prices”, The Contemporary Review 51: 355-375.

Mersch, Y (2017), “Digital Base Money: An Assessment from the ECB’s Perspective,” Speech, Helsinki, 16 January.

Nicolaisen, J (2017), “What Should the Future Form of Our Money Be?” Speech at the Norwegian Academy of Science and Letters, 25 April.

Pfister, C and N Valla (2017), “New Normal or New Orthodoxy: Elements of a New Central Banking Framework”, Manuscript, Banque de France.

Rogoff, K (2016), The Curse of Cash, Princeton, NJ: Princeton University Press.

Scorer, S (2017), “Central Bank Digital Currency: DLT or not DLT? That is the Question”, Bank Underground, 5 June. .

Skingsley, C (2016), “Should the Riksbank Issue e-Krona?” Speech to FinTech Stockholm 2016, 16 November..

Watson, A (2010), The Digest of Justinian: Volume 2, University of Pennsylvania Press.

Wicksell, K (1898), Interest and Prices: A Study of the Causes Regulating the Value of Money, Jena, Sweden: Gustav Fischer Press.

Yifei, F (2016), “On Digital Currencies, Central Banks Should Lead,” blooberg View, 1 September.

Endnotes

[1] For more detail on this, see https://www.bce.fin.ec/en/index.php/electronic-money-system.

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Topics:  Financial markets Monetary policy

Tags:  Bitcoin, monetary policy, central bank, digital currency, price-level targeting

Professor of Economics, Rutgers University

Professor of Economics, Dartmouth College; Research Fellow, CEPR

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