Central Bank Digital Currency and Transmission of Monetary Policy

Saroj Bhattarai, S. Mohammad R. Davoodalhosseini and Zhenning Zhao

Staff Working Papers from Bank of Canada

Abstract: How does the introduction of a central bank digital currency (CBDC) affect the transmission of monetary policy? Is paying interest on central bank liabilities contractionary or expansionary? Do CBDC design features—such as its substitutability with bank deposits and whether it bears interest—matter for monetary policy transmission? To address these questions, we develop a general equilibrium model with nominal rigidities, liquidity frictions, and a banking sector in which commercial banks face a leverage constraint. In the model, both CBDC and commercial bank deposits provide liquidity services to households. Banks issue deposits, extend loans to firms, and back these deposits with loans and central bank reserves. We find that an expansionary reserve quantity shock causes disinvestment, that is, higher reserves crowd out private investment. The economy’s response to an increase in the interest rate on CBDC depends on the monetary policy framework: such a change is expansionary when policy targets the reserve interest rate and contractionary when it targets the CBDC interest rate. Moreover, the response to a change in the interest rate on reserves depends on the central bank’s balance sheet management—specifically, how the quantities of CBDC and reserves are determined. Finally, CBDC design matters: imperfect substitutability between a zero-interest CBDC and deposits amplifies macroeconomic responses to monetary policy shocks, while high substitutability yields outcomes that are essentially the same as those in an economy without a CBDC.

Keywords: Digital currencies and fintech; Monetary policy; Monetary policy framework; Monetary policy transmission; Interest rates (search for similar items in EconPapers)
JEL-codes: E31 E4 E50 E58 G21 G51 (search for similar items in EconPapers)
Pages: 109 pages
Date: 2024-07
New Economics Papers: this item is included in nep-cba, nep-fdg, nep-mon and nep-pay
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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