Essays on central bank digital currency and monetary policy

Abstract

This dissertation consists of three essays examining various aspects of central bank digital currency (CBDC) and monetary policy. The first essay, coauthored with Liang Wang, investigates the effects of CBDC issuance in an economy with tax evasion and agent heterogeneity. We present a tractable model where all trades are voluntary, factoring in agent heterogeneity with unobservable idiosyncratic shocks. In the model, CBDC and cash compete as means of payment. The government can utilize CBDC to collect a labor tax, which appears to be non-distortionary. While agents with a lower marginal utility might challenge the government’s ability to finance its CBDC expenditure, we conjecture that a class of feasible policies can be identified for the optimal design of CBDC. Such policies could potentially involve higher nominal interest rates and lower inflation compared to the inflation rate associated with cash. In summary, the introduction of CBDC could enhance output and aggregate welfare by disincentivizing tax evasion. The second essay explores interest-bearing money, illiquid bonds, and banking in a news economy. Private currencies can facilitate intertemporal exchange under limited commitment, but they may exhibit excessive price volatility when backedby productive assets whose expected short-run return is subject to news shocks or flows of information. In the model, banks act as intermediaries by supplying private currencies in the form of bank deposits, backed by short-run expected returns on firms’ output pledged as collateral. Adverse news events about firm productivity in the short run can induce price volatility in bank deposits, potentially leading to a liquidity shortage. Adding household heterogeneity with news shocks results in bank deposits being priced at a premium in economies where liquidity matters, particularly during a liquidity shortage. Interest-bearing money, not backed by productive assets, can help alleviate this shortage. I show how interest-bearing money offers an additional policy tool that can help lift depressed asset prices. The interest rate affects asset prices via the investment channel, with banks using interest-bearing reserves as insurance against risk shocks. The relative insensitivity of the value of money to news events means social welfare could be improved, even if lump-sum taxation is not permitted. However, I find that the power of interest-bearing money is limited by the assumption that household preferences are publicly observable, allowing type-contingent transfers. Extending the model, an illiquid bond and a cash-in-advance constraint enable the coexistence of government debt and private currencies in the absence of news. The third essay analyzes the optimal design and implementation of CBDC in an economy where CBDC and bank deposits coexist as competing payment instruments. I develop a general equilibrium model to study the optimal design and implementation of central bank digital currencies (CBDCs) in an economy where CBDCs and private bank deposits coexist as competing payment instruments. The findings suggest that the welfare consequences of CBDCs and the policies required for first-best implementation depend on specific parameters. In sufficiently patient economies, a passive monetary policy with non-interest bearing CBDC can achieve the first-best allocation without crowding out bank deposits. Conversely, in more impatient economies, active policies with positive inflation and nominal interest rates are necessary, and interest-bearing CBDC could potentially crowd out bank deposits if the interest rate on CBDC is too high relative to deposit rates. The results highlight the importance of carefully designing CBDCs with incentive-feasible policies intended to maximize welfare and minimize risks to financial intermediation and stability. In a calibrated model representing the US economy, I find that increasing the CBDC interest rate from 0% to 5% leads to a decline of about 5% in bank deposits, while improvingoverall welfare by 2%.