Central Bank Digital Currency: Demand Shocks and Optimal Monetary Policy

2025-07-20

AI Summary

This paper investigates the transmission mechanism and welfare implications of central bank digital currency (CBDC) in response to household preference shocks within a New Keynesian framework, emphasizing CBDC–bank deposit competition under bank market power. We develop a dynamic general equilibrium model incorporating bank market power, household liquidity demand, and a Taylor-type CBDC interest rate rule. The analysis uncovers a novel transmission channel: CBDC issuance mitigates banks’ pricing power, thereby narrowing the deposit interest rate spread. Results indicate that CBDC exerts a modest expansionary effect, inducing limited deposit outflows and only mild financial disintermediation. Optimizing the CBDC interest rate rule significantly enhances social welfare, with welfare gains increasing in the CBDC yield. The key contribution lies in identifying and quantifying—previously overlooked—the welfare improvement arising from CBDC’s mitigation of bank market power.

Technology Category

• Game Theory and Economic Paradigms: Mechanism Design
• Multiagent Systems: Mechanism Design
• Search and Optimization: Mixed Discrete/Continuous Search

Application Category

• Economics, Online Markets and Human Computation: Economic aspects of blockchain and cryptocurrencies
• Web Mining and Content Analysis: Content-based information diffusion
• Security and Privacy: Large-scale security measurements

Abstract

We study the implications of a central bank digital currency (CBDC) for the transmission of household preference shocks and for welfare in a New Keynesian framework where the CBDC competes with bank deposits for household resources and banks have market power. We show that an increase in the benefit of CBDC has a mildly expansionary effect, weakening bank market power and significantly reducing the deposit spread. As households economize on liquid asset holdings, they reduce both CBDC and deposit balances. However, the degree of bank disintermediation is low, as deposit outflows remain modest. We then examine the welfare implications of CBDC rate setting and find that, compared to a non-interest-bearing CBDC, the gains with standard coefficients for a CBDC interest rate Taylor rule are modest, but they become considerable when the coefficients are optimized. Welfare gains are higher when the CBDC provides a higher benefit.

Problem

• Impact of CBDC on household preference shocks transmission
• Effect of CBDC on bank market power and deposit spreads
• Welfare implications of CBDC interest rate policies

Innovation

• CBDC competes with bank deposits
• CBDC reduces deposit spread significantly
• Optimized CBDC interest rate boosts welfare