How digital currencies could fundamentally alter monetary policy

News about bitcoin and other crypto-currencies is everywhere. But, as halfway decent MBA-student would say, you gotta worry about substitute solutions. In the case of crypto currencies like bitcoin, one such potential substitute would be a digital currency that is fully controlled by a central bank.

For this post, I present a thought experiment on how a world with only digital currencies could fundamentally alter how central banks conduct monetary policy. While this discussion is only theoretical, I think it helps show why people can get really excited about the possibilities digital currencies represent (and how digital and crypto currencies can sometimes be the same and sometimes be very different).

During recessions, central banks typically lower nominal interest rates to try and spur economic growth. If the downturn is particularly bad, they’ll keep lowering and lowering nominal rates until they reach zero (see the chart below). At this point, traditional monetary policy becomes less effective (or at least can’t be strengthened further). In economics, this is sometimes referred to as the Zero Lower Bound (ZLB) or the Liquidity Trap.

ZLB

But why can’t central banks lower interest rates below zero? Paper currency. The theory goes that in a world with paper money, whenever a central bank tried to lower interest rates below zero, people would simply withdraw their savings and hold it in cash. Think about it: if your bank was giving you -1% interest on your accounts, you could either leave it in the bank for a year and have 99% of what you started with, or hold it in cash under your mattress and still have 100%.

If all money is digital, however, there’s nothing physical for people to withdraw. Faced with the choice of losing value by keeping their money in the bank, businesses would be more likely to invest and consumers would be more likely to spend now, kick-starting growth and stimulating the economy. Basically, with a negative interest rate it makes more sense to spend your cash today rather than tomorrow (when you have less purchasing power). Thus, with digital currencies a central bank can eliminate the ZLB and further incentivize liquidity.

If you’re interested in reading more, here’s a great breakdown by my 2nd favorite econ blogger, and an overview from Business Insider with a ton of deep-dive links. As that second link notes, all of this theory relies upon the assumption that the digital currency being used is centrally controlled, which obviously doesn’t describe Bitcoin.

Finally, I should point out that various countries have tried to implement negative interest rates (with paper money), as outlined in this paper from the St. Louis Fed. With typical Fed caution, they don’t really provide any policy recommendations, but the very existence of this paper shows they’re thinking about it.

3 thoughts on “How digital currencies could fundamentally alter monetary policy

  1. Jason August 13, 2014 / 6:16 pm

    Isn’t this effectively done through inflation? If the purchasing power of your dollar is going down, no matter whether you have it in a bank or under the mattress the incentive is to invest in a growing asset (like a stock or business) rather than keep it.

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