SMU SOE Economics Lecture Series (Mar 11, 2022, 10.00am-11.30am): Cryptocurrencies and Central Bank Digital Currency

Cryptocurrencies and Central Bank Digital Currency

Digital currencies such as cryptocurrencies and central bank digital currencies (CBDCs) are on the rise. In my talk, I provide a perspective as well as details on several research papers I have written recently on these topics. The papers are written from a macroeconomic or monetary perspective. They provide a pricing model for cryptocurrencies, investigate the implication of global cryptocurrencies for international monetary competition, and examine a vexing trilemma, as central banks embark on issuing CBDCs. 

Some relevant papers (click on the title to view):

1) Currency Substitution under Transaction Costs

We consider a setting where agents can choose between two currencies to conduct their goods purchases. The usage of either currency comes with currency-specific transactions costs. For example, purchasing some goods with cryptocurrencies rather than dollars is easier and may avoid taxes. We explore an extension of Schilling-Uhlig (2019), allowing for asymmetry in transaction costs as well as dollar-bitcoin exchange fees. Agents alternate in their role as buyers and sellers, necessitating currency. A central bank steers the dollar inflation path, while bitcoins are in fixed supply. We characterize the nonstochastic equilibrium and the resulting exchange rate dynamics.

2) Some Simple Bitcoin Economics

We provide a model of an endowment economy with two competing, but intrinsically worthless currencies (Dollar, Bitcoin). Dollars are supplied by a central bank to achieve its inflation target, while the Bitcoin supply grows deterministically. Our fundamental pricing equation implies in its simplest form that Bitcoin prices form a martingale. “Mutual impatience” implies absence of speculation. Price volatility therefore does not invalidate the medium-of-exchange function. Bitcoin block rewards are not a tax on Bitcoin holders: they are financed with a Dollar tax. We discuss monetary policy implications, Bitcoin production, taxation, welfare and entry, and characterize the range of equilibria.

3) Cryptocurrencies, Currency Competition, and the Impossible Trinity

We analyze a two-country economy with complete markets, featuring two national currencies as well as a global (crypto)currency. If the global currency is used in both countries, the national nominal interest rates must be equal and the exchange rate between the national currencies is a risk-adjusted martingale. Deviation from interest rate equality implies the risk of approaching the zero lower bound or the abandonment of the national currency. We call this result Crypto-Enforced Monetary Policy Synchronization (CEMPS). If the global currency is backed by interestbearing assets, additional and tight restrictions on monetary policy arise. Thus, the classic Impossible Trinity becomes even less reconcilable. 

4) Central Bank Digital Currency: When Price and Bank Stability Collide

We build a stylized, nominal Diamond-and-Dybvig (1983) model, a consolidated central bank conducts maturity transformation, issuing on-demand, nominal liabilities in the form of an account-based central bank digital currency (CBDC) to citizens and investing the funds in a real asset. We show, the central bank's classic role as the guardian of price stability is in fundamental conflict with its role as a financial intermediator. Implementation of the socially optimal allocation requires a commitment to inflation. Commitment to price stability jeopardizes the real return on currency, and causes runs. Central bank runs manifest themselves as a 'run on the price level'.

5) Central Bank Digital Currency: Central Banking for All?

The introduction of a central bank digital currency (CBDC) allows the central bank to engage in large-scale intermediation by competing with private financial intermediaries for deposits. Yet, since a central bank is not an investment expert, it cannot invest in longterm projects itself, but relies on investment banks to do so. We derive an equivalence result that shows that absent a banking panic, the set of allocations achieved with private financial intermediation will also be achieved with a CBDC. During a panic, however, we show that the rigidity of the central bank’s contract with the investment banks has the capacity to deter runs. Thus, the central bank is more stable than the commercial banking sector. Consumers internalize this feature ex-ante, and the central bank arises as a deposit monopolist, attracting all deposits away from the commercial banking sector. This monopoly might endanger maturity transformation.

6) Parallel Digital Currencies and Sticky Prices

The rise of digital currencies may result in domestic parallel currencies. Their exchange rate shocks will present a new challenge for monetary policy. We analyze these issues in a New Keynesian framework, where firms can set prices in one of the available currencies. Price rigidity translates a one-time appreciation of a parallel currency into persistent redistribution towards the dollar sector output and inflation. The persistence lasts longer if the central bank targets “dollar”-sector inflation, rather than inflation across all currency sectors. An increase in dollar price rigidity may lead to a decrease rather than an increase of the non-dollar sector.