Interest-bearing Retail CBDC in a Small Open Economy: Implications for Welfare and the Macroeconomic Trilemma

Abstract

We introduce an interest-bearing retail central bank digital currency (CBDC) as a second monetary policy instrument to a New Keynesian small open economy model and analyze its welfare and economic implications. Our simulations find that a counter-cyclical CBDC interest rate or quantity rule enhances social welfare and economic stability. When used only domestically, an interest-bearing CBDC presents a possibility to overcome the macroeconomic trilemma: The interest rate on bonds effectively stabilizes the exchange rate movements via the uncovered interest parity, while the CBDC interest rate targets domestic inflation.

Keywords: central bank digital currency, monetary policy, blockchain, distributed ledger, small open economy, monetary policy trilemma

JEL Classification: E4, E5, F3, F4