The Monetary Policy Trilemma of CBD
The original version of the monetary policy trilemma is based on ideas from Keynes (1930) subsequently elaborated by Mundell (1963) and Fleming (1962) and ultimately popularized by Obstfeld (1997), who coined the exact formulation of a trilemma. Obstfeld and Taylor provide the following definition:
The macroeconomic policy trilemma for open economies ... follows from a basic fact:
An open capital market deprives a country’s government of the ability
simultaneously to target its exchange rate and to use monetary policy in
pursuit of other economic objectives.
(The international monetary policy trilemma) below sums up the proposition of the trilemma, which is that any monetary policy authority (government or central bank) can simultaneously only pursue two out of the three policy objectives: monetary autonomy in the management of interest rates, currency exchange-rate management, and free capital mobility.
We can also understand these three options in terms of the three functions of money: If the central bank imposes capital controls (C), it is restricting the use of national money as a means of exchange. It can no longer be used to buy and sell foreign currency. If the central bank allows currency exchange rates to float (B), it is deteriorating the function of the national money as a secure store of value. And if the central bank abandons a sovereign monetary policy (A), it is giving up on the status of the currency as a unique unit of account.
The premise of the conventional monetary policy trilemma is the co-existence of two different currencies, which are created and managed by two different central banks. This constitutes a situation of competition between two different kinds of money and two different money makers, which in turn potentially creates arbitrage opportunities for speculators/investors. In the context of our current discussion about CBDC, the situation is analogous albeit different. If we begin with the current constitution of money, we also find a situation of competition between two or three kinds of money and two different money makers. The different kinds of money are, however, not functionally equivalent in the same way as two different currencies. As we have discussed previously, cash, bank money, and central bank reserve money are qualitatively different and they do not function as perfect substitutes for each other. This means that the competition between the different kinds of money is less perfect and much more restricted than the kind of competition underlying the
Given the fact that CBDC is both electronic and universally accessible, it is functionally equivalent to bank money. This brings about a kind of competition between central bank money and commercial bank money, which is comparable to the kind of competition between different currencies found in the conventional trilemma. The implementation of CBDC thus brings about the same kinds of contradictions that are found in the conventional trilemma. Let us see how we can translate the elements of the international monetary policy trilemma onto a domestic monetary system with CBDC. The translation is illustrated in (The domestic monetary policy trilemma).
- The conventional policy objective of exchange rate management between two currencies translates into the domestic policy objective of securing financial stability by maintaining parity between commercial bank money on the one hand and CBDC and cash on the other.
- The conventional policy objective of monetary autonomy in decisions on central bank interest rates translates into monetary sovereignty, which is the prerogative of the monetary authorities to use the creation of CBDC not only as a monetary policy tool to support commercial bank credit creation but also as a fiscal policy tool to stimulate the general economy. The abandonment of monetary sovereignty means that commercial banks are the primary drivers of money creation.
- The conventional policy objective of free capital mobility translates into free convertibility between commercial bank money and central bank money. We may understand the implementation of CBDC as the introduction of such convertibility. With universal access to the central bank balance sheet, ordinary money now for the first time have the option to choose between holding electronic money with the central bank or with commercial banks.
The implementation of CBDC is the equivalent of a relaxation of capital controls as money users are now granted free convertibility as well as an opportunity for sovereign money creation as fiscal stimulus. In the following sections, we shall explore possible solutions to the contradictions that such opportunities bring about.
(The international monetary policy trilemma) below sums up the proposition of the trilemma, which is that any monetary policy authority (government or central bank) can simultaneously only pursue two out of the three policy objectives: monetary autonomy in the management of interest rates, currency exchange-rate management, and free capital mobility.
The international monetary policy trilemma
If a central bank pursues a pegged or just managed exchange rate policy
against another currency, and sets interest rates according to domestic
monetary policy goals, while at the same time allowing money to flow in
and out of the country, speculators/investors will take advantage of
interest rate arbitrage opportunities between the two currency zones.
This puts pressure on the currency and forces the central bank to do one
of three things: (A) abandon a sovereign monetary policy and bring
interest rates in line with that of the other currency, (B) allow the
currency exchange to float, or (C) impose capital controls.
We can also understand these three options in terms of the three functions of money: If the central bank imposes capital controls (C), it is restricting the use of national money as a means of exchange. It can no longer be used to buy and sell foreign currency. If the central bank allows currency exchange rates to float (B), it is deteriorating the function of the national money as a secure store of value. And if the central bank abandons a sovereign monetary policy (A), it is giving up on the status of the currency as a unique unit of account.
The premise of the conventional monetary policy trilemma is the co-existence of two different currencies, which are created and managed by two different central banks. This constitutes a situation of competition between two different kinds of money and two different money makers, which in turn potentially creates arbitrage opportunities for speculators/investors. In the context of our current discussion about CBDC, the situation is analogous albeit different. If we begin with the current constitution of money, we also find a situation of competition between two or three kinds of money and two different money makers. The different kinds of money are, however, not functionally equivalent in the same way as two different currencies. As we have discussed previously, cash, bank money, and central bank reserve money are qualitatively different and they do not function as perfect substitutes for each other. This means that the competition between the different kinds of money is less perfect and much more restricted than the kind of competition underlying the
conventional trilemma.
Given the fact that CBDC is both electronic and universally accessible, it is functionally equivalent to bank money. This brings about a kind of competition between central bank money and commercial bank money, which is comparable to the kind of competition between different currencies found in the conventional trilemma. The implementation of CBDC thus brings about the same kinds of contradictions that are found in the conventional trilemma. Let us see how we can translate the elements of the international monetary policy trilemma onto a domestic monetary system with CBDC. The translation is illustrated in (The domestic monetary policy trilemma).
- The conventional policy objective of exchange rate management between two currencies translates into the domestic policy objective of securing financial stability by maintaining parity between commercial bank money on the one hand and CBDC and cash on the other.
- The conventional policy objective of monetary autonomy in decisions on central bank interest rates translates into monetary sovereignty, which is the prerogative of the monetary authorities to use the creation of CBDC not only as a monetary policy tool to support commercial bank credit creation but also as a fiscal policy tool to stimulate the general economy. The abandonment of monetary sovereignty means that commercial banks are the primary drivers of money creation.
- The conventional policy objective of free capital mobility translates into free convertibility between commercial bank money and central bank money. We may understand the implementation of CBDC as the introduction of such convertibility. With universal access to the central bank balance sheet, ordinary money now for the first time have the option to choose between holding electronic money with the central bank or with commercial banks.
The domestic monetary policy trilemma
We propose that a monetary system with two competing money creators, the
central bank and the commercial banking sector, can simultaneously only
pursue two out of these three policy objectives. Since central banks have
not hitherto been able to create electronic money, ordinary money users
have had only a limited and inconvenient opportunity for convertibility
between commercial bank money and central bank money. Furthermore, central
banks have also had only limited opportunity to supply money directly into
the economy to provide fiscal stimulus. This means that the domestic
monetary policy trilemma has been solved by some version of (C) and (A).
The overall priority in contemporary monetary policy seems to be the
maintenance of parity between commercial bank deposit money and the two
forms of central bank money. Central banks seem to have been content with
giving up both the money users' opportunity for convertibility as well as
their monetary sovereignty to achieve this objective.
The implementation of CBDC is the equivalent of a relaxation of capital controls as money users are now granted free convertibility as well as an opportunity for sovereign money creation as fiscal stimulus. In the following sections, we shall explore possible solutions to the contradictions that such opportunities bring about.
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