The Monetary Entanglement between CBDC and Central Bank Policies

Abstract

Using a banking model, we show that the effects of introducing a Central Bank Digital Currency (CBDC) depend on the ongoing monetary policy and the amount of excess reserves. We derive the conditions for a neutral introduction without central bank pass-through funding and find that they do not always hold with quantitative easing, as bank lending shrinks if demand for CBDC is large enough. Moreover, commercial banks optimally liquidate their excess reserves to accommodate households’ demand for CBDC. Consequently, households replace banks on the liability side of the central bank balance sheet, making quantitative tightening difficult to implement.

Keywords: financial innovation, CBDC, banking, monetary policy, neutrality

JEL Classification: G2, E4, E5