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online. . . Contents I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 II. Electronic Money, Digital Currencies, Distributed Ledgers . . . . . . . . . . . . . . . . . 4 A. Cryptocurrencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 B. Central-Bank-Issued Digital Currencies . . . . . . . . . . . . . . . . . . . . . . . . 7 III. The Pros and Cons of CBDC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 A. Structural Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 B. Price and Output Stability Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 C. Financial Stability Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 IV. The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 A. Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 1. Bank Balance Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 2. Risk and Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 3. Wholesale Lending Rates and Net Worth . . . . . . . . . . . . . . . . . . . . 20 4. Retail Lending Rates and Loans, Deposit Rates and Deposits . . . . . . . . 21 5. Bank Net Worth Ownership and Dividends . . . . . . . . . . . . . . . . . . 22 B. Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 1. Optimization Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 2. Lending Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 3. Transaction Cost Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . 30 C. Financial Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 D. Unions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 E. Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 1. Government Budget Constraint . . . . . . . . . . . . . . . . . . . . . . . . . 36 2. Fiscal Policy Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 3. Determination of Individual Fiscal Instruments . . . . . . . . . . . . . . . . 38 F. Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 1. The Policy Interest Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 2. The Second Monetary Policy Instrument under CBDC . . . . . . . . . . . . 39 G. Equilibrium and Market Clearing . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 1. Individual Optimality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 2. Policy Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 3. Market Clearing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 H. Shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 V. Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 A. Pre-CBDC Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 B. CBDC Parameters - Transition Simulations . . . . . . . . . . . . . . . . . . . . . . 48 C. CBDC Parameters - Business Cycle Simulations . . . . . . . . . . . . . . . . . . . 49 1Staff Working Paper No. 605 July 2016 VI. Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 A. Steady State Effects of the Transition to CBDC . . . . . . . . . . . . . . . . . . . 50 B. Quantity Rules or Price Rules for CBDC . . . . . . . . . . . . . . . . . . . . . . 55 1. Credit Cycle Shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 2. Demand Shocks and Technology Shocks . . . . . . . . . . . . . . . . . . . . 56 3. Shocks to the Demand for Total Liquidity and for CBDC Liquidity . . . . . 56 4. The Role of Substitutability Between CBDC and Bank Deposits . . . . . . . 58 5. The Role of Uncertainty about CBDC Demand . . . . . . . . . . . . . . . . 60 C. Countercyclical CBDC Policy Rules . . . . . . . . . . . . . . . . . . . . . . . . . . 60 1. Credit Cycle Shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 2. Demand Shocks and Technology Shocks . . . . . . . . . . . . . . . . . . . . 62 3. Shocks to the Demand for Total Liquidity . . . . . . . . . . . . . . . . . . . 62 4. The Role of Substitutability between CBDC and Bank Deposits . . . . . . . 62 D. Discretionary Monetary Stimulus Through CBDC . . . . . . . . . . . . . . . . . . 63 E. Fiscal Policy Interactions with CBDC . . . . . . . . . . . . . . . . . . . . . . . . . 64 VII. Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Tables 1. Directly Calibrated Parameters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 2. Calibrated Steady State Moments and Implied Parameters Real Variables . . . . . . . 71 3. Calibrated Steady State Moments and Implied Parameters Financial Variables . . . . 72 4. Calibrated Steady State Moments and Implied Parameters CBDC Variables . . . . . . 73 5. Steady State Output Gains of Transition to CBDC . . . . . . . . . . . . . . . . . . . . 73 Figures 1. Transition to New Steady State with CBDC at 30 Percent of GDP . . . . . . . . . . . 74 2. Quantity versus Price Rules for CBDC - Credit Cyle Shocks . . . . . . . . . . . . . . . 75 3. Quantity versus Price Rules for CBDC - Higher Demand for Total Liquidity . . . . . . 76 4. Quantity versus Price Rules for CBDC - Higher Demand for CBDC Liquidity . . . . . 77 5. Low EoS versus High EoS - Quantity Rule for CBDC - Credit Cycle Shocks . . . . . . 78 6. Low EoS - Quantity versus Price Rules - Higher Demand for Total Liquidity . . . . . . 79 7. Countercyclical CBDC Quantity Rules - Credit Cycle Shocks . . . . . . . . . . . . . . 80 8. Countercyclical CBDC Price Rules - Credit Cycle Shocks . . . . . . . . . . . . . . . . . 81 9. Countercyclical CBDC Price Rules - Credit Cycle Shocks - Policy Rate Corridor . . . . 82 10. Countercyclical CBDC Price Rules - Lower Investment Demand . . . . . . . . . . . . . 83 11. Countercyclical CBDC Price Rules - Higher Demand for Total Liquidity . . . . . . . . 84 12. Countercyclical CBDC Quantity Rules - Higher Demand for Total Liquidity . . . . . . 85 13. Low EoS - Countercyclical CBDC Price Rules - Higher Demand for Total Liquidity . . 86 14. Low EoS - Countercyclical CBDC Quantity Rules - Higher Demand for Total Liquidity 87 15. CBDC-Based Discretionary Stimulus in Response to a Credit Risk Shock . . . . . . . . 88 16. Low EoS - CBDC-Based Discretionary Stimulus in Response to a Credit Risk Shock . 89 17. Distortionary Taxes - Countercyclical CBDC Quantity Rules - Credit Cycle Shocks . . 90 2Staff Working Paper No. 605 July 2016 I. Introduction This paper studies the macroeconomic consequences of a central bank granting universal, electronic, 24x7, national-currency-denominated and interest-bearing access to its balance sheet via the issuance, according to well-specified policy rules, of a centralbankdigitalcurrency CBDC. To study this issue we use a monetary-financial DSGE model, calibrated to match the United States in the pre-crisis period, that models CBDC as an imperfect substitute for bank deposits in the provision of monetary transaction services, and that models bank deposits as being created through loans or asset purchases as in Jakab and Kumhof 2015. A monetary regime with CBDC has never existed anywhere, a major reason being that the technology to make it feasible and resilient has until now not been available. There is therefore very little historical or empirical material that could help us to understand the costs and benefits of transitioning to such a regime, or to uate the different ways in which monetary policy could be conducted under it. We therefore choose the alternative approach of using a theoretical model as a laboratory where we can systematically study these issues. The model we present is detailed rather than stylised, both in order to make the rcise credible for policymakers and in order to avoid prejudging what are the most important economic mechanisms to determine the effectiveness of CBDC. Nevertheless, the modifications needed to introduce CBDC into this model are kept to a minimum in order to understand the key transmission channels more clearly. We have made considerable progress using this strategy, but much more work needs to be done. As a baseline, we consider a setting in which an initial stock of CBDC equal to 30 of GDP is issued against an equal amount of government debt, and is then, subject to countercyclical variations over the business cycle, maintained at that level. We choose 30 because this is an amount loosely similar to the magnitudes of QE conducted by various central banks over the last decade. We do not examine the question of the optimal steady-state stock of CBDC, but we note that it ought to be large enough to avoid problems with a “quantity zero lower bound” in the conduct of countercyclical policies. Our simulations suggest that this policy has a number of beneficial effects. First, it leads to an increase in the steady-state level of GDP of almost 3, due to reductions in real interest rates, in distortionary tax rates, and in monetary transaction costs that are analogous to distortionary tax rates. Second, a CBDC regime can contribute to the stabilisation of the business cycle, by giving policymakers access to a second policy instrument that controls either the quantity or the price of CBDC in a countercyclical fashion. This second policy instrument becomes especially effective in response to shocks to private money demand and private money creation, and if the substitutability between CBDC balances and bank deposits in the production of monetary transaction services is low. Financial stability considerations also generally favour the issuance of CBDC, provided that the issuance mechanism ensures that CBDC is only issued or withdrawn against government debt. On the negative side, there remains a clear concern with the proper management of the risks involved in transitioning to a different monetary and financial regime. 1 Our work is motivated by the recent emergence of private digital currencies that offer participants access to both an alternative unit of account that is governed by predetermined money supply rules, and to a new payment system that is claimed to be superior to that offered by existing 1 We should also mention that our model does not admit the possibility of bank runs in the style of Diamond and Dybvig 1983. It is however not clear whether such runs would be more or less likely under a CBDC regime. 3Staff Working Paper No. 605 July 2016 banking systems. Bitcoin was the first such system, being launched in January 2009 following the earlier release of a white paper describing its operation Nakamoto 2008. 2 A substantial number of alternatives have since been developed, 3 but at present Bitcoin remains the largest such system in operation. The monetary aspects of private digital currencies a competing currency with an exogenous, predetermined money supply are commonly held to be undesirable from the perspective of policymakers, but the innovation embodied in the payment systems of such schemes is held of some interest. It is important to stress that these two aspects of private digital currencies are logically distinct it would be technically possible to implement a distributed payment system in the style of Bitcoin that nevertheless remained denominated in a traditional currency. The question that naturally emerges is whether it might be socially beneficial to do so, 4 and it is towards this question that our paper is addressed. To the best of our knowledge, the only other theoretical work on the subject of private digital currencies is that of Fernndez-Villaverde and Sanches 2016, who explore the conditions under which multiple units of account could exist in stable currency competition, by extending the model of Lagos and Wright 2003. They demonstrate the possibility of the value of privately-issued currencies being constant over time, but show that, absent productive capital, an efficient allocation as the unique global equilibrium requires driving private money out of the economy. However, the presence of productive capital reverses this result, so that equilibria that feature the value of private money converging to zero are ruled out. In our model, we abstract from all considerations of currency competition, instead supposing an economy with a single, government-defined unit of account. Privately-created money does exist in our model, but only in the of bank deposits that maintain a 1-to-1 exchange rate with government money. The rest of this paper is organized as follows. Sect