China’s Money Market: Central Bank Digital Currency and the Future of Monetary Policy

With the popularity of the internet, several central banks around the world are actively exploring the possibility of establishing sovereign digital currencies.

China's Money Market: Central Bank Digital Currency and the Future of Monetary Policy

The article analyzes the key functions of a central bank digital currency (CBDC), focusing on the future of CBDC and central bank monetary policy around whether CBDC payments should be based on central bank accounts or tokens; whether cash should be abolished or the central bank should set a fee schedule for transfers between CBDC and banknotes; whether CBDC should bear interest or anchor an aggregate price index or have a constant nominal value like cash; the impact of CBDC on central bank monetary policy strategy and operations; and how CBDC affects the interaction between central banks and fiscal authorities.

I. How does the design of CBDC promote its role as a medium of exchange?

Money has four main characteristics, namely, a measure of value, a means of circulation, a store of value, and a means of payment, of which the measure of value and the means of circulation are the basic characteristics of money. With the popularity of the internet, several central banks around the world are actively exploring the possibility of establishing sovereign digital currencies. Central bank digital currencies (CBDCs) are inherently different from the various virtual currencies created by private entities (e.g., Bitcoin, Ether, and Ripple), whose prices have been highly volatile in recent years.

The literature already seems to suggest that the two main goals of a currency as a stable unit of account and an efficient medium of exchange are irreconcilable, but a well-designed CBDC can achieve both goals simultaneously.

In terms of the CBDC’s role as an effective medium of exchange, government fiat money has the inherent characteristics of being widely available and legal tender for all public and private payment activities. The key question, however, is whether CBDCs should be more similar to cash or debit cards? The author’s research shows that cash-like CBDCs have significant drawbacks, while debit card-like CBDCs can serve as a simple and practically cost-free medium of exchange that can be provided directly by the central bank or through a public-private partnership between the central bank and commercial banks.

(i) Token-based vs. account-based

CBDCs could be designed to resemble cash, with the central bank issuing CBDC tokens that circulate electronically with only a small amount re-deposited back to the central bank. This design would use some form of distributed bookkeeping technology (DLT) to verify the chain of ownership of the tokens and validate payment transactions without the direct involvement of the central bank or other clearing house.

Another design would be similar to a debit card, where individuals and businesses electronically deposit funds into a CBDC account at the central bank or a special designated account at a regulated depository institution. The central bank processes each payment transaction by simply debiting the payer’s CBDC account and crediting the payee’s CBDC account.

A key advantage of an account-based CBDC system is that payments can be made in real time and without cost. Of course, when each CBDC account is initially created, the identity of the account holder needs to be verified by obtaining a license or opening an account with a commercial bank. Thereafter, payment transactions can be made quickly and securely (e.g., two-step verification using a cell phone and a digital password), and the central bank can monitor any unusual activity and implement other anti-fraud safeguards if necessary.

The token-based system, on the other hand, is more expensive to verify. The entire chain of ownership of each token must be stored in an encrypted ledger (blockchain) and a copy of it must be stored on each node of the payment network. New payment transactions are collected into blocks that must be verified before they can be permanently added to the ledger. This validation process (called mining, mining) involves highly complex and energy-intensive computational procedures. As in the case of Bitcoin, the miner’s fee is equal to approximately 0.8% of the total value of the payment transaction. In fact, token-based CBDCs may be superior to the current payment system, but they are far less efficient than account-based CBDCs.

Establishing an account-based CBDC can significantly improve efficiency compared to the current cash system, and Barrdear and Kumhof (2016) state that adopting CBDC can permanently increase real GDP by about 3%.

(ii) Form of accounts

The Ecuadorian experience demonstrates the feasibility of direct account opening by the central bank to provide account-based CBDC; an alternative approach is for regulated commercial banks to provide CBDC to the public through designated accounts and hold the corresponding funds in a central bank reserve account, as per Dyson and Hodgson (2017), and the Kenyan experience demonstrates the feasibility and advantages of this public-private partnership. It should be noted that CBDCs do not have to monopolize the payment system, but in the absence of CBDC competition, private networks may benefit from scale effects and become quasi-monopolies.

(iii) Relationship between CBDC and paper money

The demand for paper money has been rapidly declining in many countries around the world, but this trend is not uniform across countries or household types, creating significant resistance to the rapid abolition of cash use. As an alternative, central banks could promote the phasing out of cash by making extensive use of CBDCs and establishing a graduated fee schedule for transfers between cash and CBDCs. For example, small and infrequent transfers would have minimal fees, while large and frequent transfers would have more substantial fees. As discussed later, this fee structure is critical to ensure that the continued existence of paper money does not limit the ability of central banks to reduce nominal interest rates to negative levels in response to severe adverse shocks. The design also contributes to individual freedom of choice and protects against tax evasion, money laundering, and other illicit activities.

Second, how does the CBDC design promote its role as a safe store of value?

How can the CBDC function as a safe store of value be enhanced, i.e., what happens to the value of funds if they are kept in a CBDC account for a longer period of time, and whether the CBDC should remain constant in nominal terms, or anchored to a broad price level and remain constant in real terms, or bear interest as in the case of short-term Treasury bonds?

(i) Constant Nominal Value

Public CBDC accounts differ from the central bank reserves of commercial banks (which usually bear interest) in that when nominal interest rates are positive, residents and businesses have an incentive to minimize the amount of funds held in CBDC accounts, so the total amount of CBDC may be relatively small.

As in current practice, central banks can conduct monetary policy by adjusting short-term nominal interest rates, but their ability to reduce nominal interest rates below zero is severely limited because depositors can move funds to zero-rate CBDCs at any time, and in times of weak aggregate demand and persistent deflation, central banks may have to rely on other instruments such as quantitative easing or government fiscal stimulus to stimulate aggregate demand and thus push the price level back to its target level.

Within the foregoing constraints on monetary policy implementation, it makes sense to maintain or even expand the inflation buffer to mitigate the severe impact of lowering the nominal interest rate floor. If the central bank sets a price level (rather than inflation rate) target, it may make more sense for the price curve to have a positive slope rather than a constant value.

(ii) The real value of stability

From a technical point of view, CBDC indexation (with the broad price index as the anchor) is fairly simple. However, when aggregate demand is suppressed and the real interest rate falls below zero, CBDC indexing will face a major problem. At this point, financial market participants will shift most of their assets to CBDCs with zero real interest rates, and the zero lower bound on real interest rates poses a stricter constraint on monetary policy than the zero lower bound on nominal interest rates. Therefore, the central bank may rely heavily on other tools such as quantitative easing or fiscal policy to achieve the goals of promoting economic recovery and restoring price stability.

(iii) Interest-bearing CBDCs

Paying interest on CBDCs may significantly enhance the competitiveness of the banking system. In a growing economy with stable price levels, CBDC interest rates are usually positive. However, in a severe economic downturn that drives down the general price level, unlike current practice where zero-interest cash severely limits the ability of the central bank to lower the policy rate (e.g., the banking panic of the early 1930s), it is feasible for the central bank to lower interest rates under a CBDC system to promote economic recovery and price stability.

The aforementioned constraints on monetary policy could be removed by establishing a graduated fee schedule for transfers between cash and CBDCs, and imposing high fees on large or frequent transfers would discourage investors from switching to cash during periods of negative nominal interest rates. Thus, the CBDC rate could be used as the main instrument of monetary policy. Moreover, there is no longer a need to maintain a positive inflation buffer.

Third, how does the CBDC design promote its role as a stable unit of account?

Providing a stable unit of account facilitates economic and financial decisions of residents and businesses, such as setting wages and prices, consumer spending and saving decisions and making financial contracts, whereas broad price stability can only be achieved by appropriately setting monetary policy.

With the introduction of CBDCs, the central bank can also continue to implement a positive inflation targeting system, and with the elimination of the effective lower bound on nominal interest rates, the establishment of true price stability will be feasible. A monetary policy framework could ensure that the CBDC value-anchored aggregate consumer price index remains stable over time.

A large literature analyzes the macroeconomic implications of anchoring the price level rather than inflation targeting, and the overall conclusion is that targeting the price level can lead to significant macroeconomic stability gains if the policy framework is transparent and the commitment to price stability is credible. Moreover, consistent with the analysis of optimal monetary policy and simple rules later, the monetary policy stance should respond to real economic activity and the price level, and the literature typically describes such frameworks as flexible price-level targeting, which differs from flexible inflation targeting in current practice.

Finally, it should be noted that a sudden shift from positive inflation targeting to stable price-level targeting may have disruptive effects on the economic and financial system, so the transition process needs to be carefully planned and managed.

IV. Monetary Policy Framework under the CBDC System

There is a broad consensus among monetary economists that the conduct of monetary policy should be systematic and transparent in order to promote the monetary transmission mechanism and central bank effectiveness. The launch of the CBDC provides a landmark opportunity to enhance the transparency of the central bank’s monetary policy framework, including its nominal anchors, instruments and operations, and policy strategy.

(i) Nominal anchors

As mentioned earlier, the monetary policy framework should provide transparent nominal anchors to facilitate economic and financial decision making by the private sector. In recent decades, there has been a significant increase in transparency as central banks have adopted specific inflation value targets, but targeting has been somewhat subjective and arbitrary, and debates over specific target values may have inadvertently damaged central bank reputations.

In contrast, if interest-bearing CBDCs are used, central banks can establish constant price level targets that can serve as durable and reliable nominal anchors.

(ii) Instruments and operations

The CBDC rate would accordingly become the main instrument of monetary policy, especially as it allows policymakers to reduce the policy rate below zero, and central bank balance sheets and operating procedures could become highly transparent.

Finally, the central bank will still need to retain its function as lender of last resort, but it is crucial to put in place appropriate legal protections to ensure that the central bank’s lender of last resort role does not undermine its ability to meet its price stability commitments.

(iii) Monetary policy strategy

One approach to the central bank’s monetary policy strategy referred to in this paper is to specify a price level target rule, which can be expressed in terms of the deviation of the price level from the target value and the deviation of economic activity from its potential target. This approach may be feasible and effective in cases where the central bank has a clear understanding of the monetary policy transmission mechanism (i.e., the dynamic relationship between the setting of the policy rate and the behavior of prices and actual economic activity). However, practice shows that current knowledge about macroeconomic dynamics has shortcomings and limitations.

Another approach is the simple rule. The simple rule for CBDC interest rate adjustment is similar to the Taylor rule, but is designed to stabilize the price level rather than stabilize the inflation rate. Like the Taylor rule, the rule can be interpreted as a benchmark for adjusting the real interest rate in response to economic activity and price fluctuations. Specifically, when the price level is at the target level and output is at potential, the ex post real interest rate should equal the equilibrium value, which may reflect the historical average real interest rate (as in Taylor’s rule) or may be set to the median estimate of professional forecasters (e.g., Levin, 2014). The value of the coefficient in the simple rule can be determined by the value that yields robust macroeconomic results derived from multiple macroeconometric models.

(iv) Monetary-fiscal interaction

Given that there is little room for arbitrage, the spread between CBDCs and short-term Treasuries is usually negligible, so changes in the size of the central bank balance sheet will not produce direct fiscal outcomes. In addition, the mint tax would disappear and the central bank would only be able to cover central bank expenditures by charging fees on small payment transactions. In addition, the maturity structure of the stock of Treasury bonds held by the public would be determined by the fiscal authorities rather than the central bank. In summary, the central bank-fiscal division of labor would return to the situation before the 2008 financial crisis, when the central bank implemented a large-scale unconventional monetary policy.

V. Conclusion: Possible risks of not using CBDC

A further important question is whether central banks should act quickly to adopt CBDCs Given the rapid innovative developments in payments technology, it may not be wise for central banks to take a reactive and inert approach to CBDCs, and there are significant risks that may arise from central banks not using CBDCs, including loss of monetary control and sensitivity to severe economic downturns.

(i) Macroeconomic instability

Under the assumptions that paper money is phased out and there is no central bank CBDC, and all payments are made using privately issued money (including virtual money), Fernández-Villaverde and Sanches (2017) show that the economy may experience uncertainty; and that issuing a central bank CBDC complemented by an appropriate monetary policy framework ensures price stability.Nicolaisen ( 2017) regarding the risks associated with the Norwegian economy no longer having any effective fiat currency also warns at a practical level.

(ii) Loss of monetary control

Suppose that paper money is obsolete and the monetary base consists only of bank reserves held by the central bank. Will the reserve rate (IOR) remain closely linked to the market rate so that the central bank can effectively regulate monetary conditions? Economic theory that the IOR as a floor for the interbank offered rate is effective in lowering the level of market interest rates contradicts recent U.S. experience, where concerns about the weak link between market rates and the IOR played a key role in prompting the Fed to introduce reverse repo instruments to deal with a broader range of counterparties. This also supports the view that publicly available interest-bearing CBDCs can ensure the central bank’s ability to manage market interest rates.

(iii) Systemic risk

Payment networks typically exhibit significant externalities and positive returns to scale, so without CBDCs, the overall private payment system could become a quasi-monopoly, at which point any significant operational problems in the payment network could pose significant risks to the entire financial system and macroeconomy.

(iv) The possibility of an extreme economic downturn

Under a non-interest-bearing central bank CBDC system, the interest rate floor may impose strict constraints on conventional monetary policy and, in turn, limit the effectiveness of forward guidance and QE policies aimed at lowering long-term yields. In addition, the feasibility of monetary-fiscal policy measures such as central bank credit subsidies, increased public infrastructure spending, or increased income transfers to households depends heavily on fickle political decisions. Therefore, under a non-interest-bearing CBDC system, the central bank may face the dilemma of “running out of ammunition.

The original article, available at, was written by Michael D Bordo and Andrew T Levin, Director of the Center for Money and Finance at Rutgers University and Visiting Fellow at the Hoover Institution at Stanford University; Levin is Levin is a professor of economics at Dartmouth College, an IMF visiting scholar, and an international fellow at the Center for Economic Policy Research (CEPR). This article represents the personal views of the authors and does not reflect the views of any other individuals or institutions. This article is compiled and published with the permission of the authors.

Author Affiliation: National Bureau of Economic Research (NBER)

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