Central bank digital currency: When price and bank stability collide

Schilling, Linda and Fernandez-Villaverde, Jesus and Uhlig, Harald (2020): Central bank digital currency: When price and bank stability collide.

Abstract

When a central bank introduces a central bank digital currency, it may lead to an erosion of deposits as the stable funding base of banks and result in challenges regarding the asset side of the central bank. We study the resulting economy and tradeoffs in a stylized nominal version of the Diamond-Dybvig (1983) model. The central bank is now involved in maturity transformation, if it so chooses. We posit that the central bank pursues three objectives: price stability, economic efficiency and financial stability. We demonstrate that a CBDC Trilemma arises: out of these three objectives, the central bank can achieve at most two. In particular, a commitment to price stability can cause a run on the central bank. Implementation of the socially optimal allocation requires a commitment to inflation.

• Item Type: MPRA Paper
• Language: English
• Keywords: CBDC, currency crises, monetary policy, bank runs, spending runs, financial intermediation, central bank digital currency, inflation targeting
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies; G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks ; Depository Institutions ; Micro Finance Institutions ; Mortgages

References

Franklin Allen and Douglas Gale. Optimal financial crises. Journal of Finance, 53(4):1245–1284, 1998.

Franklin Allen, Elena Carletti, and Douglas Gale. Money, financial stability and efficiency. Journal of Economic Theory, 149:100–127, 2014.

Franklin Allen, Xian Gu, and Julapa Jagtiani. Fintech, cryptocurrencies, and cbdc: Financial structure and transformation in china. Journal of International Money and Finance, 124: 1–13, 2022.

David Andolfatto. Assessing the impact of central bank digital currency on private banks. The Economic Journal, 131(634):525–540, 2021.

Raphael Auer and Rainer Böhme. The technology of retail central bank digital currency. BIS Quarterly Review, March, pp 85-100, March:85–100, 2020.

Raphael Auer, Giulio Cornelli, Jon Frost, et al. Rise of the central bank digital currencies: drivers, approaches and technologies. BIS Working Papers 880, Bank for International Settlements, 2020.

Raphael Auer, Holti Banka, Nana Yaa Boakye-Adjei, Ahmed Faragallah, Jon Frost, Harish Narajan, and Jermy Prenio. Central bank digital currencies: a new tool in the financial inclusion toolkit? FSI Insights 41, Bank for International Settlements, 2022.

Gadi Barlevy, Daniel Bird, Daniel Fershtman, and David Weiss. Money under the mattress: Inflation and lending of last resort. draft, Federal Reserve Bank of Chicago, 2022.

John Barrdear and Michael Kumhof. The macroeconomics of central bank issued digital currencies. Bank of England Working Paper 605, Bank of England, 2016.

Morten L Bech and Rodney Garratt. Central bank cryptocurrencies. BIS Quarterly Review September, 2017.

Aleksander Berentsen. Monetary policy implications of digital money. Kyklos, 51:89–117, 1998.

Board of Governors of the Federal Reserve System. Money and payments: The u.s. dollar in the age of digital transformation. Federal Reserve Bank, January 2022.

Michael D Bordo and Andrew T Levin. Central bank digital currency and the future of monetary policy. Working Paper 23711, National Bureau of Economic Research, August 2017.

Florian Böser and Hans Gersbach. A central bank digital currency in our monetary system? Mimeo, Center of Economic Research at ETH Zurich, 2019a.

Florian Böser and Hans Gersbach. Do CBDCs make a difference? Working paper, 2019b.

Markus K. Brunnermeier and Dirk Niepelt. On the Equivalence of Private and Public Money. Journal of Monetary Economics, 106(C):27–41, 2019.

Lorenzo Burlon, Carlos Montes-Galdon, Manuel A. Munoz, and Frank Smets. The optimal quantity of cbdc in a bank-based economy. CEPR Discussion Paper, (16995), 2022.

Guillermo A Calvo. Servicing the public debt: The role of expectations. The American Economic Review, pages 647–661, 1988.

James Chapman, Rodney Garratt, Scott Hendry, Andrew McCormack, and Wade McMahon. Project jasper: Are distributed wholesale payment systems feasible yet? Financial System, 59, 2017.

Jonathan Chiu, Mohammad Davoodalhosseini, Janet Hua Jiang, and Yu Zhu. Bank market power and central bank digital currency: Theory and quantitative assessment. Bank of Canada Staff Working Paper, (2019-20, updated May 2020), May 2019a.

Jonathan Chiu, Seyed Mohammadreza Davoodalhosseini, Janet Hua Jiang, and Yu Zhu. Bank market power and central bank digital currency: Theory and quantitative assess- ment. Available at SSRN 3331135, 2019b.

Mohammad Davoodalhosseini, Francisco Rivadeneyra, and Yu Zhu. CBDC and Monetary Policy. Staff Analytical Notes 2020-4, Bank of Canada, February 2020.

Douglas W. Diamond and Philip H. Dybvig. Bank Runs, Deposit Insurance, and Liquidity. Journal of Political Economy, 91(3):401–419, June 1983.

Douglas W Diamond and Raghuram G Rajan. Money in a theory of banking. American Economic Review, 96(1):30–53, 2006.

Dirk Niepelt, ed. Central Bank Digital Currency: Considerations, Projects, Outlook. CEPR Press, 2021.

Gauti B. Eggertsson and Michael Woodford. The zero bound on interest rates and optimal monetary policy. Brookings Papers on Economic Activity, 1:139–233, 2003.

Huberto M. Ennis and Todd Keister. Bank runs and institutions: The perils of intervention. American Economic Review, 99(4):1588–1607, September 2009.

Jesús Fernández-Villaverde, Daniel Sanches, Linda Schilling, and Harald Uhlig. Central bank digital currency: Central banking for all? Working Paper 26753, National Bureau of Economic Research, 2020.

Massimo Minesso Ferrari, Arnaud Mehl, and Livio Stracca. Central bank digital currency in an open economy. Discussion Paper 15335, CEPR, 2020.

Jonas Gross and Jonathan Shiller. A model for central bank digital currencies: Implications for bank funding and monetary policy. draft, University of Bayreuth, 2021.

Group of Thirty. Digital currencies and stablecoins: Risks, opportunities, and challenges ahead. G30, July 2020.

Stefan Ingves. Do we need an e-krona? Swedish House of Finance, 2018.

Charles J Jacklin. Demand deposits, trading restrictions, and risk sharing. Contractual arrangements for intertemporal trade, 1:26–47, 1987.

Charles M Kahn, Francisco Rivadeneyra, and Tsz-Nga Wong. Should the central bank issue e-money? Money, pages 01–18, 2019.

Todd Keister. Bailouts and financial fragility. The Review of Economic Studies, 83(2): 704–736, 2016.

Todd Keister and Daniel R. Sanches. Should Central Banks Issue Digital Currency? Working Paper 19-26, Federal Reserve Bank of Philadelphia, June 2019.

Paul Krugman. A model of balance-of-payments crises. Journal of money, credit and banking, 11(3):311–325, 1979.

Paul R. Krugman. It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap. Brookings Papers on Economic Activity, 29(2):137–206, 1998.

Finn E Kydland and Edward C Prescott. Rules Rather Than Discretion: The Inconsistency of Optimal Plans. Journal of Political Economy, 85(3):473–491, June 1977.

Christine Lagarde. Winds of change: The case for new digital currency. Singapore Fintech Festival, 2018

Cyril Monnet, Asgerdur Petursdottir, and Mariana Rojas-Breu. Central bank account for all: Efficiency and risk taking. draft, University of Bern, 2021.

Dirk Niepelt. Monetary policy with reserves and cbdc: Optimality, equivalence, and politics. CEPR Discussion Paper, (15457), 2020a.

Dirk Niepelt. Monetary policy with reserves and cbdc. Technical report, CEPR Discussion Paper, 2020b.

Maurice Obstfeld. Rational and self-fulfilling balance-of-payments crises. Technical report, National Bureau of Economic Research, 1984.

Maurice Obstfeld. The logic of currency crises. In Monetary and fiscal policy in an integrated Europe, pages 62–90. Springer, 1988.

Maurice Obstfeld. Models of currency crises with self-fulfilling features. European economic review, 40(3-5):1037–1047, 1996.

Monika Piazzesi and Martin Schneider. Credit lines, bank deposits or cbdc. draft, Stanford University, 2020.

David R Skeie. Banking with nominal deposits and inside money. Journal of Financial Intermediation, 17(4):562–584, 2008.

David R Skeie. Digital currency runs. Draft, Warwick Business School, 2019.

Harald Uhlig. A law of large numbers for large economies. Economic Theory, 8(1):41–50, 1996.

Andres Velasco. Fixed exchange rates: Credibility, flexibility and multiplicity. European economic review, 40(3-5):1023–1035, 1996.

Toni M Whited, Yufeng Wu, and Kairong Xiao. Central bank digital currency and banks. Available at SSRN 4112644, 2022.

Stephen Williamson. Central Bank Digital Currency: Welfare and Policy Implications. Technical Report 386, Society for Economic Dynamics, 2019.

Michael Woodford. Interest and Prices: Foundations of a Theory of Monetary Policy. Prince- ton University Press, 2003.