📈 economics

Central Bank Digital Currency: Demand Shocks and Optimal Monetary Policy

This paper analyzes a New Keynesian model to demonstrate that while a central bank digital currency (CBDC) mildly expands the economy by reducing bank market power and deposit spreads, significant welfare gains are achievable only when the CBDC interest rate is set according to an optimized Taylor rule rather than a standard non-interest-bearing or rule-based approach.

Original authors: Hanfeng Chen, Maria Elena Filippin

Published 2026-02-12

📖 5 min read🧠 Deep dive

CC BY 4.0

Original authors: Hanfeng Chen, Maria Elena Filippin

Original paper licensed under CC BY 4.0 (http://creativecommons.org/licenses/by/4.0/). ✨ This is an AI-generated explanation of the paper below. It is not written or endorsed by the authors. For technical accuracy, refer to the original paper. Read full disclaimer

Imagine the economy as a giant, bustling marketplace where everyone needs a way to pay for things and save their money. Right now, you have two main choices: Cash (physical money) and Bank Deposits (money in your checking or savings account).

This paper asks a big question: What happens if the Central Bank introduces a new, third option called a "Digital Dollar" (CBDC)?

Specifically, the authors want to know:

How does the economy react if people suddenly really like this new Digital Dollar?
Should the Central Bank pay interest on this Digital Dollar to help manage the economy, or should it just be like cash (zero interest)?

Here is the story of their findings, explained with some simple analogies.

1. The Setup: The "Monopoly" Banks

In the world of this paper, banks aren't all competing fiercely like gas stations on a highway. Instead, they act more like regional monopolies. Imagine you live in a small town with only one bank. That bank has a bit of power to set the rules for how much interest they pay you on your savings. They aren't perfect, but they have a "markup" (a little extra profit) because you don't have many other choices.

2. The Shock: Everyone Suddenly Loves the Digital Dollar

The researchers simulated a scenario where people suddenly realize the new Digital Dollar is amazing. Maybe it's safer, easier to use, or just feels more secure (like a "flight to safety").

What happened?

The Economy Got a Little Bump: Surprisingly, the economy didn't crash; it actually grew a little bit. People started spending more and working a bit less (because they felt wealthier).
The Banks Lost Their Grip: This is the most interesting part. Because the Digital Dollar was so attractive, the banks lost their "monopoly power." They couldn't charge as high a "fee" (interest spread) on deposits anymore because people had a better alternative.
The "Paradox" of Less Money: Here's the twist. Even though the Digital Dollar became more popular, people actually held less of it and less in their bank accounts.
- The Analogy: Imagine you find a super-efficient water bottle that holds more water than your old one. You don't need to carry two bottles anymore; you just carry one super-bottle. Similarly, because the Digital Dollar is so efficient, people needed to hold less total money to get the same "liquidity" (spending power). They didn't run to the bank to withdraw everything; they just needed to keep less cash overall.
No Bank Run: A major fear is that everyone will dump their bank deposits into the Digital Dollar, causing banks to collapse. The study found this didn't happen. The shift was small. Banks were fine.

3. The Big Question: Should the Digital Dollar Earn Interest?

Currently, many Central Banks are thinking about making the Digital Dollar like cash: it earns 0% interest. But the authors asked: What if we treat it like a policy tool and pay interest on it?

They tested two scenarios:

The "Lazy" Rule: The interest rate on the Digital Dollar just follows the standard interest rate (like a shadow).
The "Smart" Rule: The Central Bank optimizes the interest rate specifically to help the economy, reacting to inflation and unemployment in a very precise way.

The Results:

The "Lazy" Rule: Doing nothing special (just following the standard rate) gave a tiny, almost invisible benefit.
The "Smart" Rule: When the Central Bank used a "Smart" rule to optimize the Digital Dollar's interest rate, the benefits were huge.
- The Analogy: Think of the economy as a car. The standard interest rate is the gas pedal. The Digital Dollar interest rate is a turbocharger. If you just use the gas pedal, you get a normal ride. But if you tune the turbocharger perfectly (optimize the rule), the car runs much smoother and faster, especially when the road gets bumpy (economic shocks).

4. The Twist: It Depends on the Banks

The "Smart" rule looked different depending on how the banks were behaving:

If Banks are Monopolies (like in the real world): The Central Bank should use the Digital Dollar interest rate to fight both inflation and unemployment.
If Banks are Perfectly Competitive: The Central Bank should use the Digital Dollar interest rate only to fight unemployment. It should ignore inflation and let the standard interest rate handle that.

The Bottom Line

This paper suggests that a Central Bank Digital Currency isn't just a new way to pay for coffee. It's a powerful new tool.

It won't kill banks: Even if people love the Digital Dollar, banks won't lose all their deposits.
It can boost the economy: If designed well, it can make the economy more stable and efficient.
Don't ignore the interest rate: If the Central Bank just makes a "dumb" Digital Dollar (zero interest), they miss out on a massive opportunity to help people. But if they "tune" the interest rate perfectly, it could significantly improve everyone's financial well-being.

In short: A Digital Dollar is like a new instrument in the Central Bank's orchestra. If they just let it play the same notes as the rest of the band, it's fine. But if they give it a solo and tune it perfectly, the whole symphony sounds much better.

1. Problem Statement and Motivation

The paper addresses two critical questions regarding the introduction of Central Bank Digital Currencies (CBDCs) in advanced economies:

Transmission Mechanism: How do shocks to household preferences for CBDC (specifically, changes in the perceived benefit of CBDC) transmit to the broader macroeconomy?
Optimal Policy Design: How should CBDC interest rates be set to maximize household welfare, and how does the optimal policy depend on the structure of the banking sector (monopolistic vs. competitive) and the level of CBDC adoption?

The authors highlight a gap in existing literature regarding the interaction between CBDC, bank market power, and monetary policy transmission. While many studies assume competitive banking or focus solely on financial stability, this paper explicitly models banks as regional monopolists with pricing power in the deposit market to analyze how CBDC competition affects deposit spreads and welfare.

2. Methodology

The authors construct a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model with the following key features:

Households: Households derive utility from consumption, labor, and a composite liquidity service ( $z_t$ ) composed of CBDC ( $m_t$ ) and bank deposits ( $n_t$ ). The liquidity aggregator uses a Constant Elasticity of Substitution (CES) function, allowing for time-varying preferences ( $\lambda_t$ ) and substitutability ( $\epsilon_t$ ) between CBDC and deposits. Households face a budget constraint involving bonds, capital, and liquid assets.
Banks: The banking sector is modeled as a set of regional monopolists. Banks issue deposits to finance capital and reserves. Crucially, they face a cost of issuing deposits that depends on their liquidity ratio (reserves/deposits). Because they are monopolists, they set deposit rates with a markup over marginal cost. This markup is inversely related to the elasticity of demand for deposits, which is influenced by the substitutability between CBDC and deposits.
Firms: The model includes final goods firms (perfectly competitive), intermediate goods firms (perfectly competitive with capital and labor), and retail firms (monopolistically competitive with Calvo price rigidity).
Government/Policy: The government issues bonds, reserves, and CBDC.
- Standard Policy: The bond rate ( $R_t$ ) follows a standard Taylor rule targeting inflation and output.
- CBDC Policy: The CBDC rate ( $R^m_t$ ) can be set via a Taylor-type rule or fixed (non-interest-bearing).
Shocks: The model incorporates structural shocks to productivity, government spending, markups, and crucially, preference shocks to the CBDC benefit ( $\lambda_t$ ) and the elasticity of substitution ( $\epsilon_t$ ).
Welfare Analysis: The authors employ the approach of Schmitt-Grohé and Uribe (2007) to optimize Taylor rule coefficients ( $\theta_\pi, \theta_y, \rho$ ) numerically to maximize the expected discounted utility of households. Welfare gains are measured as compensating fractions of steady-state consumption-liquidity bundles.

3. Key Contributions

Modeling Bank Market Power: Unlike many CBDC models that assume perfect competition, this paper explicitly models banks as monopolists. This allows for the analysis of how CBDC competition erodes bank market power and reduces deposit spreads, a mechanism often overlooked.
Preference Shock Transmission: The paper isolates the macroeconomic effects of a "flight to safety" or increased utility from CBDC ( $\lambda_t$ ), showing how such shocks interact with the banking sector's pricing power.
Optimal CBDC Rate Rules: The paper provides a rigorous welfare analysis of setting CBDC interest rates via a Taylor rule. It contrasts non-interest-bearing CBDCs with optimized interest-bearing CBDCs under different banking structures.
Disintermediation Dynamics: The paper challenges the narrative of massive bank disintermediation, finding that even with high CBDC benefits, deposit outflows remain modest due to household optimization of liquid asset holdings.

4. Key Results

A. Transmission of CBDC Preference Shocks

Expansionary Effect: A positive shock to the CBDC benefit (e.g., a 25% increase in $\lambda_t$ ) has a mildly expansionary effect on the economy. Output, consumption, and inflation rise, while investment declines slightly.
Deposit Spread Compression: The most significant mechanism is the reduction in the deposit spread. As the perceived benefit of CBDC rises, the substitutability between CBDC and deposits increases the elasticity of demand for deposits. This erodes the banks' market power, forcing them to lower the markup on deposits.
Asset Holdings Paradox: Despite the increase in aggregate liquidity services, households reduce their holdings of both CBDC and deposits. This occurs because the higher utility per unit of CBDC allows households to economize on total liquid asset holdings.
Low Disintermediation: The shift from deposits to CBDC is limited. The degree of bank disintermediation is low because the reduction in deposit balances is modest.
Role of Banking Structure: In a competitive banking scenario, the deposit spread does not change (as there is no markup to compress). Consequently, the transmission of the shock is minimal, and the macroeconomic response is negligible compared to the monopolistic case.

B. Optimal Monetary Policy and Welfare

Welfare Gains from Optimization:
- Using a non-optimized Taylor rule for CBDC (standard coefficients) yields only modest welfare gains (0.01%–0.03%) compared to a non-interest-bearing CBDC.
- Using optimized Taylor rule coefficients yields considerable welfare gains, ranging from 2.25% to 7.04% of steady-state consumption-liquidity bundles.
Impact of CBDC Benefit ( $\lambda$ ): Welfare gains from an optimized CBDC rate increase as the perceived benefit of CBDC ( $\lambda$ ) increases.
Optimal Policy Rules by Banking Structure:
- Monopolist Banks: The optimal CBDC rate should react to both inflation and output. The weight on inflation depends on the level of CBDC benefit (higher benefit $\rightarrow$ lower inflation response weight). The output response magnitude is consistent.
- Competitive Banks: The optimal policy is starkly different. The CBDC rate should ignore inflation entirely and react maximally to output fluctuations. This suggests a division of labor where the standard bond rate stabilizes inflation, and the CBDC rate stabilizes output.
Interest Rate Smoothing: The optimization results consistently suggest that interest rate smoothing (inertia) for the CBDC rate is undesirable (optimal inertia $\rho^m_R \approx 0$ ).

5. Significance and Policy Implications

Design Matters: The paper demonstrates that the macroeconomic impact of CBDC is heavily dependent on the banking sector's structure. In markets with significant bank market power, CBDC acts as a powerful disciplinary tool that reduces deposit spreads and improves welfare.
Policy Instrument Potential: While many central banks are considering non-interest-bearing CBDCs to minimize risk, this paper argues that an interest-bearing CBDC with an optimized Taylor rule can significantly enhance welfare, particularly by acting as a complementary tool to stabilize shocks that the standard policy rate cannot fully address.
Stability vs. Efficiency: The findings suggest that fears of massive bank disintermediation may be overstated. Even with high CBDC adoption, the banking sector remains stable, and the primary effect is a more efficient pricing of liquid assets rather than a collapse in bank funding.
Strategic Allocation of Tools: The result that CBDC rates should focus on output in competitive markets (or both in monopolistic markets) offers a novel framework for central banks considering a multi-instrument monetary policy framework.

In conclusion, the paper provides a robust theoretical foundation suggesting that while CBDC introduction poses manageable risks to bank funding, its potential as a welfare-enhancing monetary policy instrument is substantial, provided its interest rate is optimized and tailored to the specific market structure of the banking sector.