Digital turnaround in monetary policy? – The monetary policy aspects of central bank digital currencies

V. Digital turnaround in monetary policy? – The monetary policy aspects of central bank digital currencies

Dániel Felcser – Zsolt Kuti – Gergő Török

The wave of digitalisation seen in recent decades has reached central banks too. Besides the decline in the demand for cash, monetary policy also has to face external challenges in the future, and in this context central banking discourse has increasingly included the concept of central bank digital currencies (CBDCs). The introduction of a CBDC means that the central bank provides nonfinancial actors access to its balance sheet. A deposit-taking central bank only accepts deposits from non-financial actors, while a creditor central bank lends directly to the private sector. Should the central bank implement the CBDC as an interest-bearing asset, it would gain a new monetary policy instrument for bypassing money markets and directly influencing the behaviour of non-financial actors. In the case of a creditor central bank, monetary policy transmission could strengthen further because the volatility of business cycles can be better mitigated through central bank lending. Moreover, a CBDC can also facilitate the introduction of even more accommodative and targeted monetary policy instruments.

However, CBDCs currently exist only as a theoretical concept, so there are no experiences about their impact on monetary policy and the real economy. Introduction is a highly complex and fairly unpredictable process, compounded by the issues of operational implementation as well. It raises adjustment issues for the banking system and, in the case of a creditor central bank, it may lead to the build-up of credit risk on the central bank’s balance sheet. Due to the above, CBDCs’ benefit–cost balance can only be estimated with a great degree of uncertainty.

1. Introduction – What are central bank digital currencies?

1.1. Introductory thoughts

The digitalisation seen in the past decades has also had a massive impact on the monetary system, and therefore monetary policy has to face new external challenges. Virtual

currencies such as bitcoin appeared, so money and the financial infrastructure can now be created and operated without financial actors and central banks. This could also mean that central banks may lose control over money issuance and interest rate setting. As electronic payments and new technological solutions became widely used, and cash use declined in some countries, the need arose among households and non-financial actors to access safe central bank money electronically too. Currently, cash is the only risk-free option for holding money that is widely available and represents a claim on the central bank.

As part of the above processes, the concept of a central bank digital currency (CBDC) arose in economic literature and among

central banks. A CBDC is a type of non-physical (electronic) money issued by the central bank for economic agents. The potential introduction and widespread adoption of such currencies could fundamentally change our monetary system and central banks’ monetary policy.

1.2. A new challenge for central banks

In recent years, a number of more or less independent factors have emerged that could reduce the efficiency of the monetary policy transmission mechanism in the longer run:

1. The potential widespread use of virtual currencies, and the rise of technology companies and online commerce. 2. The emergence of a cashless society and the loss of access to central bank money. Although they are currently unable to fulfil the basic functions of money, virtual currencies (such as bitcoin) have been designed

to enable transactions by circumventing traditional financial

actors. The benefits offered by them have not been realised yet, but it cannot be ruled out that a virtual currency could once appear that becomes highly popular. Another factor is that tech giants (e.g. Facebook, Google and Amazon) hold increasing market power. If these corporations start offering account-keeping

services besides their main activities, consumers will conduct

some of their financial transactions via those accounts. Since the buyer and the seller are in the same ecosystem, no funds move between banks during the transactions. Ultimately, Facebook also attempts to achieve this with its Libra project, during which the company is set to create its own infrastructure with its own, independent currency. In these cases, the efficiency of the

monetary policy transmission mechanism could decrease, as economic agents prefer these assets to traditional legal tender

when they need to pay. The extent of this decline depends on the amount of goods and services available in the ecosystems. Under such a scenario, the changes in monetary conditions would be felt much less, which would lead to a weakening of monetary policy’s efficiency and the anchoring of expectations.

Digitalisation has also transformed everyday financial habits, and therefore several central banks have seen the demand for

cash fall, in some cases dramatically. If cash disappeared, nonfinancial actors would be unable to hold a risk-free means of payment. First, this entails operational risk because all transactions would be conducted electronically, through a single infrastructure, and second this would make it difficult for certain participants to complete payments. Therefore, the issuance of central bank

digital currencies often comes up in connection with Sweden, where unique processes can be observed in payments, for

various reasons: Sweden has one of the lowest cash-to-GDP ratios, coupled with one of the highest number of electronic payments per capita, while money demand diminishes even in nominal terms (it has halved since 2007) (Riksbank, 2017). The Swedish central bank has made rapid progress in research (Riksbank, 2018) and testing (Riksbank, 2020) regarding the introduction of the so-called e-krona and its impact. The Riksbank examines the

possibility of digitalising cash, which would offer an alternative to economic agents that could be used to hold risk-free central bank money even when cash will no longer be ‘generally accepted’.

It is uncertain to what extent the factors described above threaten the efficiency of the monetary policy transmission mechanism in the longer run, just like the question of what the best central bank response to this could be. What is certain, however, is that the appearance of virtual currencies has introduced a new type of money, and an even more innovative category, the concept of central bank digital currencies has entered economic discourse as a potential solution.

1.3. Classification of the different forms of money and the concept of central bank digital currencies

The different forms of money and their development can be examined along four main aspects when defining central bank digital currencies: 1. Issuer

2. Form (electronic or tangible) 3. Anonymity 4. Accessibility One important aspect is whether the given money is issued by the central bank or another organisation, as money that represents a claim on the central bank is risk-free and its acceptance is guaranteed by law. Currently, the only form of money

representing a claim on the central bank that is available to all

economic agents is cash (Figure 1). Even though commercial

bank deposit money can be converted to cash, it represents

a claim on the commercial bank (for central bank money). Since commercial banks may become insolvent in certain cases, commercial bank money is not risk-free.

Figure 1: A system of different categories of money

Digital

Internet money

Bank deposit

Central bank reserves and settlement account

Central bank deposit account

CBDC (only for a limited group of partners)

CBDC (universally accessible)

Central bank issued

Cash Virtual money

Widely accessible

Community money

Peer-to-peer

Note: The central bank deposit account indicates the case when non-bank participants may also place a deposit with the central bank. Internet money is a money that can be purchased in various online games but can be spent only within the game. Source: Bech, M.–R. Garratt (2017).

Of course, nowadays in a digital age, usability is also heavily influenced by the fact whether money is stored electronically or in physical form. At present, economic agents can only conduct

electronic payments by using deposits held at commercial

banks. Nevertheless, cash has not had a viable alternative in fast, peer-to-peer, small amount transactions, but the appearance of mobile apps (e.g. Alipay, WeChat, Revolut or Swish in Sweden) marked a turning point in this. Another crucial feature is anonymity, which is usually regarded as an advantage (or disadvantage, depending on the viewpoint) of cash over electronic forms of money. Anonymity is also a major

feature of many virtual currencies, because the currently available electronic payment methods (bank transfer, card payment) cannot be anonymous (now). The fourth characteristic is accessibility, i.e. whether a given type of money is widely available (to consumers and companies) or it is accessible only to a small group of users (e.g. commercial banks, the state). Central banks already issue electronic central bank

money, but it is only available to central bank counterparties

(and some public entities). (The central bank keeps an account for commercial banks, where for example the transfers among banks are recorded, along with the results of central bank operations.) Based on the above, a CBDC can be defined as central

bank-issued legal tender that is electronic, widely accessible

and accepted (also by consumers and non-financial corporations, which may not necessarily include non-residents). The central bank can decide whether to allow anonymity, in other words this aspect depends on the central bank’s intention and the way the CBDC system is implemented. It should be stressed once again

that as CBDCs are central bank-issued, they are considered a claim on the central bank and thus a risk-free form of money.

1.4. Possible ways and aims of introducing a CBDC

From a conceptual perspective, a CBDC can be introduced in

three principal ways. The differences between the methods are not only technological, they also differ in fundamental considerations reflecting the aim of the central bank with introducing the CBDC.

As a result, the various versions exert a vastly different monetary policy impact.

The main premise of the register- or account-based approach is that central banks can keep accounts for not only a limited group (such as commercial banks or the state) but also for a wide range of consumers, potentially millions of people. This method allows larger sums to be used and held securely on an electronic account, so it mostly resembles commercial bank accounts. Accordingly,

this solution can mainly be used if the central bank wishes to substitute commercial bank deposit money, providing risk-free central bank money to economic agents and employing the CBDC as a monetary policy instrument.

The other implementation method is the value-based approach. The essence of this is that the central bank money is recorded on a device (card) or (mobile) application, similar to today’s prepaid cards. This solution is mainly useful for retail, anonymous

payment transactions. In such a scenario, the CBDC primarily substitutes cash, it is not a monetary policy instrument, and the balance presumably does not bear interest.

2. The impact of introducing a central bank digital currency on the central bank’s operating environment

The introduction of a CBDC would have a major impact on the entire banking and financial system, which is crucial from

the perspective of monetary policy transmission. The CBDC may affect commercial banks’ funding costs, lending capacity and thus also the development of credit cycles, and it can also influence economic growth. Also, its introduction may transform the balance sheets of some participants. Before presenting the

central bank’s monetary policy with a CBDC, the major changes have to be described.

2.1. Opening the central bank’s balance sheet and issuing a CBDC

The introduction of a CBDC also means that the central bank provides non-financial actors access to its balance sheet,47 which can happen in two ways. In the first case, the central bank only

47 Although non-financial actors already have access to the central bank’s balance sheet through cash, the paper refers to digital access.

opens the liabilities side of its balance sheet, allowing deposits to be placed on the accounts kept by it (deposit-taking central bank). In the second case, besides facilitating the liabilities-side deposits, the central bank provides access to its assets side, meaning that it also grants loans to non-financial actors (creditor central bank) (Figure 2).

Figure 2: Access to the balance sheet of deposit-taking and creditor central banks

Central bank partner group

Assets Liabilites

Current (no CBDC)

Commercial banks Commercial banks

General government

After the introduction of CBDC

+ Nonfinancial private sector (credits) + Nonfinancial private sector (deposits)

Source: Authors’ work.

Creditor central bank Deposit-taking central bank

In the case of a deposit-taking central bank, the CBDC is created by participants converting cash and depositing the CBDC on their central bank account, or they transfer their commercial bank deposit money from their commercial bank account to the central bank. Some argue that the central bank should design the CBDC framework in a way that only a limited amount of

central bank digital currency is created to protect commercial bank deposits. In such a case, the central bank would only credit the CBDC on the accounts against some collateral, for example government securities (Kumhof, 2018). However, this could be circumvented with an operation carried out by commercial banks,48 so making the creation of CBDC subject to this condition does not materially influence the amount of commercial bank deposit money flowing into it. The popularity of a CBDC is probably determined by a combination of several other factors, for example the relative interest rate compared to bank deposits and cash, confidence in commercial banks and the central bank as well as the quality and pricing of account-keeping services. It should be noted that

with a deposit-taking central bank, the amount of money in circulation does not change due to the transfer of the CBDC to

the account, only its structure changes, i.e. the entity that keeps it on their balance sheet and the balance sheet item where it is kept.

In the case of a creditor central bank, the deposit-placing option is complemented with central bank lending, because concurrently with the crediting of the loan on the assets side, the

loan amount appears on the liabilities side, too (in line with the endogenous money theory), and therefore new money, CBDC is created. Unlike in the deposit-taking scenario, the CBDC created through the lending of the creditor central bank increases the amount of money in circulation.

48 When a customer initiates a transfer into CBDC, the commercial bank first buys government securities for the given amount and then transfers that to the account of the central bank, which, in exchange, credits CBDC to the customer’s account. The outcome is the same, only the operation is more complex.

2.2. Changes to the operation of commercial banks

The introduction of a CBDC affects the entire financial system, therefore it would greatly influence how commercial banks function, which would also have monetary policy implications.

When an account-based CBDC is introduced, the central bank performs account-keeping services to economic agents, inevitably becoming a ‘competitor’ to commercial banks. Therefore, some of the accounts held with commercial banks may be terminated, and at the same time payments and other services would be taken over by the central bank, which could reduce commercial bank revenues.

When the central bank competes in account-keeping services, commercial banks’ funding costs may increase, as the introduction of a CBDC could lead to an increase in deposit

rates. The advantage of deposit money over cash is that it can be used more conveniently, in electronic payments. The introduction

of a CBDC would eliminate this advantage of commercial bank deposit money, forcing commercial banks to pay higher interest

on the deposits placed with them. If the central bank pays interest on the CBDC, that sets the minimum level of risk-free interest rate available in the economy. This may raise deposit rates, because

the interest paid by commercial banks on the deposits placed with them must be higher than the CBDC rate.

Another aspect that needs to be examined is central bank standing facilities, in other words whether the central bank is willing to lend to commercial banks. When funds flow out from commercial banks (currently, this can take the form of a depositor transferring money to another bank or withdrawing cash; in the case of a CBDC, something similar happens when customers convert their deposits to CBDC), upon settlement, the commercial bank

reduces central bank liquidity or it has to borrow from the

central bank (this is called standing facility) (Figure 3). This is one of the factors that allow commercial banks to lend and create money.

Figure 3: Impact of the flow of demand deposits to CBDC on the size of the central bank’s balance sheet

There is sufficient liquidity in the banking system

Deposit-taking central bank

There is insufficient liquidity in the banking system There is a realignment from bank reserves to the CBDC.

The size of the central bank balance sheet does not change.

Commercial banks need refinancing.

The central bank balance sheet is rising.

Source: Authors’ work.

If standing facilities are available to commercial banks, the latter’s lending processes may be reflected on the central bank’s

balance sheet, as borrowers may wish to transfer the loan amount to their more secure CBDC account. In this case, commercial banks do not have to be concerned about illiquidity, because they know that the central bank grants them credit upon request. However,

if the loans extended by commercial banks are in default, commercial banks cannot meet their obligations against the central bank, and the credit risk appears on the central bank’s

balance sheet. Commercial banks’ non-performing loans can quickly lead to moral hazard (one only needs to think of the ‘too-big-to-fail’ problem) when banks undertake excessive risks due to short-term profit considerations. Moreover, this can also

undermine the efficiency of the monetary policy transmission mechanism, as lending processes would respond less to changes in the interest rate environment, because, owing to moral hazard, they would have other motivations.

However, if standing facilities are not available to commercial banks, the size of deposits and other liabilities previously

collected limits commercial banks’ lending capacity. This could curtail lending too much, which jeopardises economic growth and may also influence the efficiency of monetary policy. Furthermore, the lack of availability may also lead to increased volatility in the interbank rate due to deposit outflows.

2.3. Transformation of the balance sheets of each actor

To analyse the monetary policy effects, it should be examined how the balance sheets of the different actors would be

transformed following the introduction of a CBDC. This chapter presents today’s monetary system, before turning to the effects of a CBDC issued by a deposit-taking central bank.

Balance sheets in today’s monetary system Figure 4 shows the balance sheets of the various sectors, with a special focus on how they change when commercial banks lend to the non-financial private sector. For simplicity’s sake, the figure concentrates on domestic developments and does not include non-residents. In today’s monetary system, when commercial banks extend a loan, they also create deposit money. As a result, lending increases the balance sheets of the banking system and the private sector, as credit and deposits expand in parallel (dotted area). However, the central bank’s balance sheet is unaffected by lending.

Figure 4: In the current monetary system, credit is created by crediting it as a deposit

Central bank Commercial banks Private sector Assets Liabilites Assets Liabilites Assets Liabilites

Foreign exchange reserves

Credits for commercial banks Cash

Commercial banks' deposits Central bank deposits Central bank credits

Credits↑ Deposits↑ Cash

Deposits↑ Others (net)

Others (net) Debt of general government (net)

Credits↑

Demands on general government (net)

Note: The balance sheets in this chapter are for illustrative purposes only, the relative proportions of the items are not necessarily realistic. Dotted areas indicate changes in balance sheets. Source: Authors’ work.

Deposit-taking central bank If the central bank introduces a CBDC, the CBDC can drive out cash and/or deposits, which transforms participants’ balance sheets (Figure 5). As the private sector withdraws deposits from the banking system, commercial banks have a financing requirement against the central bank. In other words, the central bank would provide more credit to commercial banks, thereby indirectly financing the private sector, which would mean an indirect credit risk and increase the central bank’s balance sheet. With a deposit-taking central bank, commercial banks would

continue creating money, but some of the credited deposits may flow to the CBDC, so banks may need refinancing from the central bank.

Figure 5: Transition to the deposit-taking central bank system

Central bank

Commercial banks Private sector

Assets Liabilites Assets Liabilites Assets Liabilites

Foreign exchange reserves Cash↓

CBDC↑↑ Central bank deposits Central bank credits↑ Cash↓

CBDC↑↑ Others (net)

Credit for commercial banks ↑ Others (net) Commercial banks' deposits

Debt of general government (net) Credits Deposits↓

Deposits↓

Demands on general government (net) Credits

Source: Authors’ work.

3. Monetary policy transmission and the operation of conventional monetary policy

The previous chapters examined how the introduction of a CBDC influences the operation and balance sheet of the different actors and how it affects the real economy. This chapter takes a look at monetary policy transmission and the possibility of a new instrument, i.e. the interest paid on the CBDC.

The account-based CBDC that is available to a wide range of partners exerts the greatest monetary policy impact: its introduction makes the central bank toolkit more complex, enabling the central bank to directly influence the behaviour of non-financial actors, along with money market conditions.

A CBDC can facilitate new monetary policy instruments and unconventional instruments hitherto existing only in economic theory.

3.1. Monetary policy objectives and instruments

If the central bank issues a CBDC, it needs to decide about other important aspects, therefore its set of instruments potentially

becomes more complex. Besides the two former types of central bank money, i.e. cash and commercial bank reserves, a new, third type appears, with potentially different conditions than the former two. Thus, there are three types of money supplied by the central bank. If the CBDC is introduced, the central bank needs

to decide on the following:

1. the exchange rate between the CBDC and cash and commercial bank deposit money; 2. whether to determine its amount or price (interest rate); 3. whether the CBDC should bear interest, and if yes, how; 4. whether there should be quantitative limits for individual money holders. Although this may seem trivial, if there is a fixed exchange rate between cash and the CBDC (for example one unit of the digital currency equals one unit of cash or commercial bank deposit money), the central bank needs to decide whether to determine the amount or interest rate of the CBDC to preserve market equilibrium.49 If the central bank decides to pay the holder

interest on the CBDC, a new monetary policy instrument could

be utilised that allows the central bank to be in direct contact with households and non-financial corporations (ECB, 2020).

However, in this case, the amount of CBDC in circulation is

determined by the demand from economic agents (just like with cash nowadays).

49 When the amount of the CBDC, or supply, is limited, for example in a financial stress, the holders may be willing to pay more than one unit of cash or commercial bank money for one unit of CBDC. If the central bank wants to maintain the 1:1 exchange rate, the supply of the CBDC cannot be fixed.

The central bank can also decide to limit the amount held on

individual CBDC accounts based on some consideration (for example tying it to median income due to macroprudential considerations), which may have two aims. First, it can curb the flow of commercial bank deposits and thus slow down the expansion of the central bank’s balance sheet, and second, in times of financial turbulence, ‘digital bank runs’ (when actors suddenly want to convert huge amounts of commercial bank deposits to CBDC) can be prevented. Nonetheless, here the efficiency

of the CBDC is much lower in terms of monetary policy, so central banks need to assess the significance of the different considerations.

3.2. The impact of central bank digital currencies on the current transmission channels

Among the monetary policy transmission channels, the interest rate and risk-taking channels would be most affected by the

introduction of a CBDC. In line with Balogh–Horváth–Kollarik (2017), the (broad) interest rate channel includes not only the traditional interest rate channel but also the credit channel. Since, at least in the versions where the commercial bank money and the CBDC are convertible, the banking system’s money-creating and lending capacity may change, the transmission of the central bank’s interest rate conditions through the banking system may also vary. And this concerns mainly the above-mentioned two channels.

Keeping everything else constant, using a CBDC could lead to tighter monetary conditions. The interest rate on demand deposits has been typically below the central bank base rate (Meaning et al., 2017), and it was near the bottom of the interest rate corridor in the past decade. However, the introduction of the CBDC could result in rising funding costs for banks in two ways. – First, as the CBDC has better liquidity characteristics than cash, it should have a higher equilibrium price than cash. In this case,

the price of the CBDC is its opportunity cost, i.e. the differential between the interest rate on demand deposits and the CBDC interest rate. Therefore if the central bank continues to pay zero interest on the money issued by it, the interest rate of demand deposits would climb. – Second, in the version where the central bank would provide refinancing to the banking system to replace the outflow of deposits, some of the demand deposits bearing interest below the base rate would be replaced by loans bearing interest at (or above) the policy rate.

However, the greater competition for keeping deposits may also prompt commercial banks to quickly adjust the interest on the demand deposits collected/created by them when the central bank changes its own interest rate conditions.

3.3. The CBDC as a new monetary policy instrument

If the central bank decides to pay interest on the CBDC, it has a new monetary policy instrument in its toolkit. Changes to the interest on the CBDC are directly felt by CBDC account holders, whose consumption and saving decisions are therefore adjusted to the changed interest rate environment more quickly.

A potential benefit of this new instrument is that the central bank would be able to shape consumption and investment developments more efficiently and separately (Figure 6). It would be in direct contact with non-financial participants thanks to the CBDC interest rate, any change in which would urge households to fine-tune their consumption decisions. Meanwhile, the base rate could be used to influence companies’ investment decisions through shaping money market rates and lending rates.

Figure 6: Separation of investment and consumption processes

Investments

Interest rate of CBDC

Consumption

Base rate

Monetary policy

Source: Authors’ work.

Yet it is uncertain whether the changes to the interest rate of the CBDC weaken or strengthen the impact of the adjusted money market rates, or whether it does not influence their impact.

Moreover, if money markets need some time before adjusting to a changed interest rate environment, the question arises whether the effect of the central bank’s rate-setting decision

reaches the economy in waves (CBDC account holders adjust first, then traditional channels exert their impact) (Figure 7).

Figure 7: Channels of the different interest rates

Investment

Internal delay Base rate

Interest rate perceived by economic agents

Real economic effect Central bank decision Revaluation in financial markets

Interest rate of CBCD

Reálgazdasági reakció

Source: Authors’ work.

Consumption, saving

Case study: Reducing the interest on the CBDC

If the central bank cuts the CBDC’s interest rate, it makes

sense for commercial banks to reduce deposit rates as well. If commercial banks decrease deposit rates less (Figure 8), money holders may find it better to hold their money in commercial bank deposits rather than CBDC. Meanwhile, commercial banks also benefit from collecting deposits to repay their central bank loans, because this entails a lower interest burden. So the cuts to the CBDC interest rate boost deposits and reduce CBDC holdings (Figure 9). All in all, the lowering of the CBDC interest rate

leads to a contraction of the central bank’s balance sheet as CBDC flows to commercial bank deposits, while the efficiency of interest rate transmission is maintained.

Figure 8: How deposit rates respond to a reduction of the interest on the CBDC

Interest rate of CBDC Interest rate of deposits Base rate

Decrease by 10 basis points

Source: Authors’ work.

Decrase by less than 10 basis points

By reducing the interest on the CBDC, further monetary easing

can be achieved. First, the interest realised on the private sector’s CBDC holdings can be directly reduced, which can primarily influence consumption and savings. Second, among commercial bank liabilities, deposits start crowding out central bank funds, while the former are cheaper. This could decrease banks’ average cost of funds, leading in turn to a drop in lending rates.

Figure 9: By reducing the interest rate of the CBDC, liquidity flows from the CBDC to cash and deposits

Central bank

Commercial banks Private sector

Assets Liabilites Assets Liabilites Assets Liabilites

Foreign exchange reserves Cash↑

CBDC↓↓ Central bank deposits Central bank credits ↓ Cash↑

CBDC↓↓ Others (net)

Credits for commercial banks↓ Commercial banks' deposits

Others (net) Debt of general government (net) Credits Deposits↑

Deposits↑

Debt of general government (net) Credits

Note: It was assumed that the general government balance would not be affected by the measure. In reality, however, it is likely that both private sector debt and central bank claims would increase (for example, through the issuance of government securities or the sale of central bank government securities). Source: Authors’ work.

3.4. Special issues related to creditor central banks

The main difference between deposit-taking and creditor central banks is that in the latter case, the central bank allows non-financial actors to access not only the liabilities side of its balance sheet but also the assets side. In practical terms, this means that the central bank lends directly to the private sector.

As a result of central bank lending, the newly disbursed loans increase the size of the central bank’s balance sheet, and their repayment reduces it. If this process is examined across business cycles, it can be assumed that the central bank’s balance sheet changes in line with the business (and credit) cycles: when lending picks up in an upswing, this process is partly reflected on the central bank’s balance sheet.

While deposit-taking central banks only become ‘competitors’ to commercial banks in account-keeping, creditor central banks also compete in lending. However, it is unclear what considerations would inform the decision of private actors when choosing between borrowing from commercial banks or the central bank. If central bank lending is only moderately popular, the current operation of commercial banks does not change much, but the more popular it is, the smaller the market share remaining for commercial banks, which could reduce market competition.

Direct central bank lending could have various advantages

for monetary policy. When economic growth slows down, commercial banks’ risk appetite usually declines, too, which further deepens the slump. If in such a situation the central bank does not cut back lending or does so only slightly or it compensates for the reduced amount of commercial bank loans, the economic downturn can be reduced.

From the perspective of the efficiency of monetary policy, central bank lending raises two questions. First, it may increase the efficiency of transmission, as it directly influences lending processes through setting lending rates, and second, commercial banks also adjust to the changed central bank lending rates due to market competition. Moreover, even if money markets do not operate properly for some reason, the efficiency of interest rate transmission may be maintained nevertheless, and money markets do not need to reprice. In normal times, money market repricing can occur faster and more efficiently overall (Figure 10).

Figure 10: Monetary transmission without money market repricing

Internal delay Base rate

Interest rate perceived by economic agents

Real economic effect

Central bank decision Revaluation in financial markets

Interest rate of CBDC

Real economic response

Source: Authors’ work.

Consumption, saving + Investment

On the other hand, the efficiency of central bank lending can be weakened by several factors. From an operational viewpoint, most central banks do not have the infrastructure necessary for lending: they have no countrywide branch network or the

necessary headcount, and the scant experience in lending and the lack of familiarity with customers may also be limiting factors. Furthermore, some kind of moral hazard arises for central banks, too, if they start overlending due to some consideration unrelated to the central bank mandate. Direct and not sufficiently prudent

lending to the private sector may entail substantial credit risk on the central bank’s balance sheet, which could significantly undermine the efficiency of monetary policy transmission under adverse circumstances.

One should also mention the potential effect of creditor central banks and the CBDC on fiscal policy. First, if CBDC flows onto the central bank’s balance sheet due to commercial banks’ lending processes, and the central bank extends loans to commercial banks in exchange, it has to run an indirect credit risk. Second, if the

central bank engages in lending, direct credit risk builds up on

its balance sheet. If the ratio of non-performing loans increases in a crisis, ultimately losses could arise on the central bank’s balance sheet. If the central bank needs recapitalisation due to the losses,

the room for fiscal manoeuvre could become limited (depending on the regulations in effect, although the Czech central bank

operated with negative equity), which may make it difficult or even impossible to pursue a countercyclical fiscal policy, and the downturn could deepen (Figure 11). Granted, these risks can be mitigated by the collateral valuation system (haircuts), and credit institutions’ own funds may also provide a line of defence to the central bank.

Figure 11: Potential effects of an economic downturn

Economic downturn

Increase in non-performing loans

The room for maneuver of fiscal policy is narrowing

Source: Authors’ work.

Central budget covers the losses of the central bank

Loss at the central bank

4. The CBDC as an unconventional instrument

In the recent decade, the renewal of central bank instruments was also warranted by crisis management. Central banks first attempted to mitigate the adverse economic effects of the 2008 financial crisis using traditional monetary policy instruments: robust rate-cutting cycles were started and liquidity-providing instruments were expanded (MNB, 2017). Even in the decades

prior to the 2008 financial crisis, the gradual decline of inflation was coupled with decreasing policy rates, therefore central banks quickly hit the lower bound of nominal interest rates while attempting to provide the necessary monetary easing.

Conventional interest rate policy did not prove to be sufficient in crisis management, and consequently central banks increasingly used new, unconventional instruments to further ease monetary conditions (Karácsony–Kuti–Török, 2019).

With persistently low real interest rates, monetary policy is more likely to hit the lower bound of nominal interest rates in the

future, too (Figure 12). The additional impact of the programmes similar to those used in earlier times could gradually diminish (BIS, 2017), therefore targeted instruments could increasingly come into focus. Their targeted nature also means that central banks can use several instruments on several markets at the same time to improve monetary policy transmission. One theoretically possible way to expand the room for manoeuvre is the introduction of a central bank digital currency.

Figure 12: The rate of central bank base rates in countries around the world

Policy rate (percent) -0,75 4 10+

Note: darker color indicates lower interest rates (April 2021 data). Source: own editing, tradingeconomics.com.

The introduction of a CBDC can facilitate the application of new monetary policy instruments that have only existed in theory and that could mainly be used when the lower bound

of nominal interest rates is reached. Yet the current monetary framework provides an opportunity for using a wide range of central bank instruments besides the ‘usual’ unconventional ones, as central bank responses to the coronavirus pandemic demonstrate.

It can be seen that in itself the CBDC could act as a fine-tuning

instrument exerting its effect through the traditional

transmission channels as described above, which could support monetary policy transmission and establish a direct link between the central bank and non-financial participants.

The introduction of a CBDC may also facilitate the introduction of even more accommodative and targeted monetary policy

instruments. It should be underlined that these are mostly theoretical concepts that have already been discussed in economic thinking and the literature, and there are great uncertainties as to their efficiency and transmission. The two instruments below could function as brand new and independent instruments, but it should be borne in mind that their implementation also raises

legal issues.

4.1. Using deeply negative interest rates

If CBDC was the only type of central bank money available to everyone (i.e. cash disappeared), in theory the lower bound of nominal interest rates could be eliminated. Currently, the zero yield on cash means the lower limit to bank deposit rates.50 If cash disappeared, the alternative form of liquid saving would be CBDC, and the central bank can pay negative interest on that, especially in the case of extreme shocks, to ensure price stability (Dyson–Hodgson, 2016; Goodfriend, 2016; Bech–Garratt, 2017). The idea behind using deeply negative interest rates is that the substitution effect (if interest is the price for future saving)

50 The effective lower bound is slightly below zero, as holding cash entails costs.

is strong, therefore households increase their consumption

spending and reduce their savings. Ultimately the central bank would support the economy and facilitate the rise in inflation by boosting aggregate demand. However, using negative interest rates raises several issues, as there can be numerous unintended side effects: – Consumption may not be encouraged if the income effect can exceed the substitution effect. This means that negative interest rates decrease the value of long-term savings (for example in the case of pension savings, more has to be put aside in the present to achieve a given pension payment), which reduces

current consumption, therefore this measure would be contrary to the intentions.

– The feasibility of negative interest rates can be uncertain even when a CBDC is used. Economic agents may opt for other money substitutes that are a better store of value (Keynes, 1936, p. 382). Residents can flee negative interest rates even in

the absence of cash by conducting transactions and keeping

their savings in a foreign currency. (This has become easier in recent years, one only has to think of the Revolut app, which can be used to digitally and conveniently convert any currency.) – Finally, it should be noted that the negative interest paid by money holders would mean implied taxation. This would

be completely contrary to central banks’ crisis management practices, according to which they seek to manage an economic

crisis by providing the necessary liquidity. Furthermore, such a step would probably reduce the social acceptance of a CBDC, which would have longer-term negative consequences on its use.

4.2. The concept of helicopter money

With a CBDC, it would be technically easier for the central bank to use helicopter money than nowadays. The concept got its name from Friedman’s (1969) thought experiment where

real economy actors (households) receive transfers from the central bank, in other words the central bank would credit

a certain amount to households’ CBDC accounts. This is not only about the expansion of money supply and liquidity (and the corresponding drop in interest rates), but also about the directly received disposable income of households. If a major portion of economic agents, or all of them, have a CBDC account, it is technically easier for the central bank to give them money to influence their consumption decisions. However,

there are several arguments against using helicopter money.

Issues could arise if households use up the money received from the central bank quickly and at the same time, because this concentration of increased demand leads to excessive inflationary pressure, which could be even stronger when coupled with a supply shock. Furthermore, some households may use the amount received as savings, purchasing financial or real assets,

which may threaten with bubbles on the affected markets. Nevertheless, the above problems can be addressed by choosing

the right way of implementation (Hampl, 2018). Sudden surges in demand and the conversion of helicopter money into savings could be prevented by setting a time limit on utilising helicopter money and the amount that can be spent during that period could be limited by the central bank (for example there would be six months to spend it, in fixed maximum monthly instalments). In

such a case, consumption could be better smoothed in a crisis,

leading to a smaller downturn in consumption. In addition, the central bank can also determine the areas where the money can be used, which can prevent asset price bubbles. But using helicopter money also raises legal issues: if the losses of the central bank are covered by the budget, even if the central bank seems to provide money to economic agents directly, the general government also takes part in the process. This raises

the issue of monetary financing.51 Second, as helicopter money is a sort of transfer to households, this is a quasi-fiscal activity, which should not be performed by the central bank, even if driven by monetary policy considerations.

4.3. The CBDC and the basic credit line

Recently, the idea of a basic central bank credit line entered

economic thinking, as an alternative to universal basic income. The implementation of a basic central bank credit line can be facilitated and promoted by the existence of a CBDC, and this could have several advantages.

A possible way of implementation would be to automatically make the basic central bank credit line part of private sector CBDC accounts. This would provide a predictable, sustainable and stable line of credit to all participants in the private sector.

For non-financial corporations, this would serve as a sort of safety net in temporary difficulties, or it could be used to finance an investment. For households, it can help smooth consumption, for example in brief periods when income declines for some reason. And it can also contribute to the establishment of new businesses when it can be used as equity, because the overall willingness to enterprise may boost economic growth.

Furthermore, the basic central bank credit line can also act as an

automatic stabiliser. In an economic shock, when a company faces a temporary but sudden drop in its revenues, the credit line offers a lifeline to the otherwise viable business. For example, the first wave of the coronavirus pandemic was such a shock, when many firms in all walks of business life suddenly found themselves in a difficult situation due to the shutdown.

51 Currently, Article 123 of the Treaty on the Functioning of the European Union prohibits monetary financing in the EU.

5. Conclusion

The central bank digital currency can be realised in various schemes, which have vastly different effects on the economy and monetary policy. The challenges relevant from a central banking perspective can determine whether a CBDC would rather replace cash or commercial bank money. The greatest monetary policy

effect is exerted by a widely available, account-based and

interest-bearing CBDC. The main question is whether the central bank would only collect deposits (deposit-taking central bank) or lend, too (creditor central bank).

The potential introduction of a CBDC would also expand the

central bank’s set of instruments. It would allow the central bank to deal directly with households and non-financial corporations and thus directly influence their economic decisions. If the CBDC also bears interest, any change in interest rates through the CBDC appears immediately in the real economy, without the lag of money markets. This helps the central bank to more directly

influence consumption and saving decisions, while investment and lending processes can be controlled in a targeted manner with the conventional instruments. A creditor central bank lends directly to the private sector.

Central bank lending can improve the efficiency of the monetary policy transmission mechanism, as there would be no need for money market repricing, and the interest on central bank loans would be a kind of benchmark rate to which commercial banks would need to adjust. The advantage of this is that if not properly functioning money and credit markets slowed down economic growth, the central bank could mitigate the economic impact

directly, by shaping lending processes. However, several potential risks can arise, because direct lending to the private

sector could lead to a build-up of substantial credit risk on the

central bank’s balance sheet, which could constrain the room for manoeuvre of monetary policy and even fiscal policy under adverse circumstances.

The appearance of a CBDC enables the application of several unconventional instruments, which have only existed in theory, when the lower bound of nominal interest rates is reached.

Such new instruments include deeply negative central bank rates and helicopter money. However, in the absence of empirical experiences, their actual impact mechanism can only be estimated with a great degree of uncertainty.

Overall, the implementation of a CBDC could result in significant changes in the operation of central banks and monetary policy. If risks are assessed and managed appropriately, a central bank digital currency can be central element in a new, more efficient and more targeted monetary policy framework.

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