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Central Bank Digital Currency – First Movers Have An Advantage In Open Economies

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Many central banks are complacent about working in earnest on a central bank digital currency. Their attitude is that it is a risky proposition with lots of unknowns; let someone else be on the bleeding edge and work out the kinks in the system before joining the fray. Another consideration is specificity, emerging market and developing economies have other fish to fry, a CBDC is probably one of the last items on their agenda. However, there is a compelling case to be made for CBDC used by emerging markets and developing economies to leapfrog developed nations. This is evident in the CBDC related activity from the Bahamas to the Caribbean to Jamaica to the Marshall Islands.

A recent article addresses the issue of a CBDC in an open economy setting. Another assumption is that the CBDC remunerates its holders; remunerates is a loaded word, it refers to interest bearing instruments. When such interest can be negative, the word remunerate can cause confusion. The other assumption is that a CBDC from one country (they call this the home country) can be used in another country (the foreign country). All of these depend on the features of a CBDC. Economists call them technical features; for a technologist they are just plain features.

So to recap, the paper addresses a remunerated CBDC in an open economy, a home country that has a CBDC allowing foreigners to hold CBDC with no limit and a foreign country (or countries) that have no native CBDC. Open economies feature free movement of CBDC between countries, with no legal restrictions. The model used in the simulation concludes that features of a CBDC- scalability, liquidity, safety, remuneration could cause an uncovered interest rate parity during a productivity shock in the home country.

A shock in the home country leads to a magnification of its effects in the foreign country in the presence of a CBDC; primarily caused by a run into the CBDC issued by the home country during the monetary policy and demand adjustments that take place. This is true when the interest rate of the CBDC is similar to that of bonds; the CBDC is also more desirable due to its liquidity. The foreign country has to work harder to control its monetary policy.

Given this setting, the foreign central bank has to be up to twice as reactive to control inflation and output as the home country. The mitigating features of a CBDC to soften these effects have to be limits for foreigners holding CBDC, or flexibility in the interest rates or both. It is not clear that countries would incorporate these features into their own CBDC to assist foreign central banks. Since autonomy in monetary policy can be regained by the issuance of a CBDC domestically, suggests a “significant first mover advantage”.

The ideas in this paper must be discussion topics in ECB and other central banks; especially in light of the imminent release of DCEP by People’s Bank of China. China is not an open economy in many senses of the word; but they are gradually loosening control of their currency. The Chinese CBDC will be used heavily in the belt and road countries. Another factor to be considered is the relative size of the home country economy and the foreign countries economies.

This is a result of a simulation run on a model, since economics is a social science and not a hard science, these are not like the equations of physics. In fact, the so called Taylor rule cannot be followed in times of stress like stagflation, or a shock to GDP like the pandemic. Missed predictions on inflation in the last two decades using simulations and classic economic theory show how difficult it is to model the real world with its tangled dependencies and unknown causality.

Credit: Vipin Bharathan

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