Monetary policy of cryptocurrencies, explained

The design choices, such as the level of privacy — i.e., anonymous or fully traceable transactions — implemented in the creation of a CBDC can have significant implications for monetary policy. 

Continuing the privacy design choice example, let’s understand its impact on monetary policy in the following two scenarios.

Scenario 1: Anonymous and untraceable transactions

It might be more challenging for central banks to develop certain monetary policy instruments that depend on transaction data to monitor and control the money supply if a CBDC is created to be entirely anonymous and untraceable. 

For instance, if a CBDC is entirely private, it could be more challenging for central banks to identify and stop illegal activity, such as money laundering and tax evasion, which might have an influence on the stability of the financial system and the efficacy of monetary policy. The use of CBDCs to execute policies such as capital limits or negative interest rates may also make it harder for central banks to monitor and regulate.

Capital limits are limitations on the total amount of CBDC that a person or organization may own. Capital restrictions can be used as a measure to prevent CBDCs from being hoarded and promote consumption, which will help the economy thrive. Capital restrictions, however, may also have unforeseen effects, such as increasing demand for alternative assets or changing the composition of the money supply.

When the interest rate on deposits is negative, depositors must pay the bank to store their funds rather than earning interest — i.e., interest rates on deposits fall below zero. This is referred to as a negative interest rate at banks, when a central bank uses a negative interest rate policy to encourage investment and expenditure during economic downturns. 

A CBDC may also enable central banks to execute negative interest rate policies that promote expenditure and discourage hoarding if they are intended to be interest-bearing. Negative interest rate policies, however, may also have unintended consequences that could increase financial instability by decreasing the incentive for savers to deposit their money in banks.

Scenario 2: Transparent and traceable transactions

On the other hand, a CBDC might possibly offer central banks useful data insights into consumer behavior and economic patterns, which could guide their policymaking processes if it is created to be completely transparent and traceable. However, it could also raise concerns about privacy and surveillance.

Therefore, central banks will need to carefully consider the trade-offs between these policies and ensure they are designed in a way that supports economic growth and stability while minimizing the risk of another global financial crisis.