Central Bank Cryptocurrency
Imagine a small country IEOnia, in which the Central Bank has abandoned its old national currency with a substantial share of cash and introduced a new virtual sovereign currency based on blockchain. The new system is cashless, and all other (private) currencies are prohibited. Instead of holding cash, every person and every firm has a digital wallet operated by the Central Bank. The money in this wallet can be disposed of freely; the Central Bank may set an interest rate for the money in the wallet. The commercial banks' sector in the economy is highly competitive.
In this task, you are asked to discuss the possible features of the IEOnian economy.
(a) (10 rp) The monetary policy in traditional systems has a fundamental problem called 'zero lower bound.' How will this be affected by the introduction of the new system?
The zero lower bound problem means that it is difficult to decrease interest rates (conduct expansionary monetary policy) when the deposit rate is near zero. This is because people will withdraw money from commercial banks and keep them in cash. A cashless system removes this problem; banks (including the CB) may effectively pay the negative interest rate because depositors have no other option of storing money
(b) (10 rp) How will the Central Bank digital currency affect interest rate spreads (lending rate minus deposit rate) of commercial banks?
Short answer:
- Either: same deposit rates, more concentration in the lending market – higher spreads.
- OR: higher deposit rates by commercial banks to attract funds, more transparency in credit history – lower spreads.
- OR: higher deposit rates by commercial banks to attract funds, funding risk hence higher lending rates – ambiguous effect on spreads.
Longer answer:
Commercial banks and CB will be in competition for the depositors' money. While commercial banks could default and endanger deposits (that is why deposit insurance is necessary to avoid bank runs), CB offers effectively safe deposits. Banks will face a withdrawal of funding by people and firms because many will prefer a riskless wallet with CB given that the deposit interest rates are the same. Competeing with each other and with the CB, commercial banks will raise the deposit rates and thus decrease the spreads.
For commercial banks to stay in business, they would need to rely more heavily on other sources of funding, like issuing bonds. Provided a highly competitive environment, some banks will leave the market. Note that CB does not lend to firms or individuals, hence the lending market will be more concentrated. Remaining banks will charge higher interest from borrowers both because of higher cost of funding and more market power in lending.
So, there are effects both ways.
(c) (10 rp) Provide one more economic consequence of the new system that you find significant.
Key ideas: decreased tax evasion and money laundering, increased tax revenues, more opportunities for financial surveillance, potential issues with international trade, higher consumer spending because of lower "pain of paying", etc.