For decades, households and businesses have steadily increased their use of electronic options for making payments. These options have eroded the popularity of traditional physical currency. Mindful of this trend, policymakers around the world are looking more closely at potential roles for digital currencies issued directly by central banks. Indeed, one central bank digital currency (CBDC) is already in circulation, but a central fact remains: The basic economic implications of introducing a CBDC are not well understood.1 How would a CBDC affect interest rates on traditional bank deposits? What effect would it have on loan markets? Would investment activity decline? Todd Keister and Daniel Sanches explore these and other questions in their working paper, “Should Central Banks Issue Digital Currency?”

By designing a model that tracks changes in the equilibrium level of interest rates (and, by extension, changes in economic activity and overall investment levels), Keister and Sanches can study several costs and benefits of CBDCs. Specifically, they can quantify how the introduction of a new digital currency could affect the broader economy, and they can compare these effects to outcomes within a baseline economic model that uses traditional currency.

The authors make clear that introducing a CBDC provokes an acute competition between the new currency and its traditional counterpart. In other words, the economists do not assume that the currencies would be perfectly complementary. Rather, they conclude that tensions would exist between the two forms of payment, creating frictions and interactions that would have to be accounted for. After all, they argue, there is bound to be a disturbance when a new currency is ushered into a banking system that has long operated on the back of a single currency.

Whereas earlier research focuses on how CBDCs increase the assets held by central banks, Keister and Sanches analyze the CBDC exclusively as a new form of money. They piece together the relationships that determine how this newborn currency is likely to influence traditional methods of exchange (and, by extension, the broader economy), and they do so by designing a model that's simple, concrete, and descriptive. This model simulates the actions and preferences of a diverse collection of buyers and sellers, spanning an economy that accommodates physical as well as digital currencies. Notably, the model incorporates the behavior of private banks, which provide essential services for economic growth (including loans for commercial investments).

The model reveals that when a central bank issues a universal cryptocurrency (that is, a cryptocurrency that can be used across all types of transactions, whether as cash or as a bank deposit), some degree of positive social value is created, and this value intensifies when credit markets are operating smoothly and the economy is generating a large volume of transactions. In this scenario, the interplay between the demand for digital currencies and the appetite for traditional currencies produces profitable credit conditions for private banks, who are thereby incentivized to write more loans, creating a social benefit. The authors point out, however, that a downside exists as well: A universal CBDC likely dents the popularity of traditional bank deposits, and this displacement comes at a cost (as touched on below).

Alternatively, when the digital currency is not universal but is instead highly targeted, the model suggests that it can increase aggregate liquidity within the economy and boost economic activity.2 At the same time, if the currency is designed to behave like a bank deposit, it can potentially exacerbate certain negative economic developments. During periods of friction within credit markets, for instance, when loan approvals decrease and loan issuance wanes, a deposit-like CBDC can make conditions even tougher. The authors' analysis indicates that better results could be achieved by issuing two targeted CBDCs — by adding a cashlike version slated for very specific transactions — though this scenario would face significant technical challenges. How, for instance, to prevent the cashlike CBDC from being used for transactions that often use bank deposits (such as online purchases)? The paper questions whether bitcoin technology is sophisticated enough to ensure that the currency is used only in cashlike transactions.

As is the case with a universal cryptocurrency, introducing a targeted version would likely lead to a decline in the popularity of bank deposits. The economists caution that this could be costly, because it would push up interest rates while crimping bank-financed investment.3 However, Keister and Sanches reiterate that both types of digital currency could have positive effects on social welfare. The desirability of each type of CBDC, they say, depends on trade-offs between such positive and negative considerations.

Having explained the nature of the trade-offs associated with the two types of CBDCs, the authors assert that policymakers will likely face a choice in which “either type of CBDC may be desirable, either type alone may be desirable, or both types may be desirable.” In each case, central-bank officials will seek to identify an optimal interest rate that facilitates exchange while maintaining the viability of traditional private banks. Put another way, policymakers will be charged with implementing the interest-rate policy that makes transactions easier to conduct while preserving the role of the existing banking system (and the benefits it provides to society).4

Policy officials globally have begun deliberating the adoption of CBDCs, though the macroeconomic ramifications of such currencies are yet to be fully understood. By designing a model that simulates a CBDC’s introduction into a legacy banking system, Keister and Sanches illuminate some of the policy tradeoffs that arise when a CBDC competes with traditional means of exchange such as cash and bank deposits. Their paper describes how central banks can use a digital currency to facilitate the exchange of goods and services while minimizing negative consequences for banks, consumers, and the broader economy. Their analysis offers a glimpse into what is likely to be a historic  development in the realm of central-bank policy.

  1. The views expressed here are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
  2. The Sand Dollar, issued under the purview of the Central Bank of The Bahamas, began circulating in 2020.
  3. A highly targeted CBDC is a substitute for either bank deposits or physical currency, but not both. A deposit-like CBDC would adopt, as much as possible, the features of a bank account, such as a tool to check the account balance, overdraft rules, and rules for account transfers. A cash-like CBDC would adopt, as much as possible, the features of physical banknotes, such as being able to transfer values offline and conduct anonymous transactions.
  4. Keeping an eye on how to mitigate the phenomenon, the authors examine how private banks might be “crowded out” in this manner. They ask, for instance, if central banks should lend to private banks, thereby helping them offset the losses incurred from being crowded out by the digital currency. They find that when their model is extended to simulate such lending, the economic ramifications essentially net out to zero: There is no change in equilibrium interest rates, bank lending, or bank liabilities. The model shows, in short, that central banks cannot use lending as a way to offset the negative effects of digital currencies.
  5. The deployment of CBDCs involves additional costs not discussed in this summary. The authors mention, for instance, the potential for CBDCs to be used for illicit activities. They also discuss the possibility that consumers who don’t have access to digital tools will be shut out of CBDC-based transactions.