Monetary Policy with Digitial Currency

Thank you for your interest in my last article. I want to discuss some issues connected to monetary policy here and make some of the issues more understandable. I hope you like my posts and find them informative!

Michael Bordo and Andrew Levin discuss in a short paper the prospects of introducing digital currency held directly at the central bank. It is a worthwhile read if you are interested in future paths of monetary policy. The main proposal is to introduce digital currency issued by the central bank and managed centrally by the central bank. This would allow for fast, almost costless transactions using digital currency instead of cash. A point not directly mentioned by the authors, is that it would found a payment system which runs in parallel to the traditional payment system that works through deposits at private banks. Since the central bank cannot go bankrupt, this payment system would be insulated from any kind of risk and work through every kind of economic turmoil turmoil.

The really interesting consequences are in connection to the conduct of monetary policy. At the moment monetary policy is constrained by what is called the effective lower bound on nominal interest rates, that is that the policy rate set by the central bank can be marginally negative, but not too much. This means that in times of severe crisis, the policy the rate can be to high in relation to what would be necessary to bring about economic recovery. Many economists argue that this was the case after the 2008-2009 recession. Because digital currency would be held directly at the central bank, it is possible to pay an interest rate on such accounts. This would make savers indifferent between holding other riskless assets and digital currency, which would bring about the optimal money supply as mentioned by Friedman. Another point is that, as long as paper currency is abolished at the same time, nominal interest rates would not be constrained by the effective lower bound anymore. Nominal interest rates could become temporarily negative instead, cutting short the recession and at the same time minimizing the cost for savers associated with low interest rates over a medium horizon.

Such digital currency would also allow the central bank to have a more direct control over the money supply, as it can issue digital currency directly at will instead of using deposits via banks. Interestingly, also not directly discussed in the paper, it would also allow to use other policy instruments such as helicopter money, i.e. the issuance of new currency and crediting private accounts with those amounts. It remains to be discussed, however, if such policy instruments remain interesting in an environment in which negative nominal interest rates are feasible.