Exploring CBDC Impacts on Macroeconomic Dynamics: A Working Paper by the European Central Bank

The European Central Bank (ECB) recently published a working paper on May 8th, 2023, diving into the complex world of Central Bank Digital Currencies (CBDCs) and their potential impact on the economy. The paper, titled “CBDC and business cycle dynamics in a New Monetarist New Keynesian model,” provides a deep-dive into the intricacies of an economy intertwined with CBDCs.

To embark on this exploration, the authors of the study ingeniously integrate a New Monetarist-type decentralized market into a New Keynesian model with financial frictions. This hybrid model, featuring a centralised market (CM) and a decentralised market (DM), helps to simulate the potential impact of an interest-bearing CBDC on the economic landscape.

The centralised market (CM) in the model encapsulates the New Keynesian dynamics, introducing familiar frictions such as monopolistic competition among retail goods producers and Calvo-type sticky prices, which allow for real effects of monetary policy. In addition, the model includes investment adjustment costs for intermediate goods-producing firms and a unique incentive constraint for bankers, leading to frictions in the bank intermediation process.

In contrast, the decentralised market (DM) is a monetary search model, providing a platform for CBDCs and bank deposits to function as a medium of exchange. Here, households receive a preference shock at the beginning of the DM, determining their roles as sellers or buyers, creating a double-coincidence-of-wants problem.

The study shows that the introduction of an interest-bearing CBDC can help stabilize the liquidity premium. This can influence bank funding conditions and the opportunity costs of money, potentially smoothing the reaction of investment and consumption to macroeconomic shocks.

An increase in CBDC supply, which leads to a decrease in the liquidity premium, can boost consumption, output, and inflation. The study underlines the pivotal role of the central bank’s adjustments to the CBDC supply in response to changes in the liquidity premium in shaping the dynamic impact of the CBDC on the economy.

The findings suggest that the existence of a CBDC does not significantly alter the model’s responses to typical macroeconomic shocks. Instead, it tends to dampen and smooth their transmission to core variables such as output and inflation.

By integrating the New Monetarist decentralised transactions with the New Keynesian business cycle dynamics, this research provides a comprehensive framework to evaluate the properties and impacts of CBDCs.

The implications of this study are profound, casting light on how CBDCs could affect monetary policy, financial stability, and the broader role of digital currencies in our economic systems. As central banks worldwide continue to explore the potential of CBDCs, this research presents a crucial step towards understanding the multifaceted effects of these digital currencies.

Find a full paper here: