Central Bank Digital Currency with Adjustable Interest Rate in Small Open Economies

Abstract

Open economy implications of central bank digital currencies (CBDCs) are a new and exciting area of research. In this paper, we assess the economic and welfare outcomes of monetary policies with an adjustable interest rate of a CBDC as a secondary instrument and a Taylor-type rule as a primary instrument in a small open economy. We develop a dynamic stochastic general equilibrium (DSGE) model, in which bank deposits and CBDC are competing media of exchange, and are both competing assets of domestic and foreign bonds. The model provides parity conditions between CBDC vis-a-vis its competing assets, which imply that the efficiency in transacting with CBDC plays an important role in determining both the interest rate differentials and the effectiveness of the adjustable CBDC interest rate as a monetary policy instrument. Our simulation exercises find that a counter-cyclical rule for the CBDC interest rate improves social welfare, despite the distributional effects among financially constrained and unconstrained agents. We also find that the adjustable CBDC interest rate provides a possibility for the central bank to achieve both objectives of monetary autonomy and exchange rate stability, in a way analogous to a sterilized foreign exchange intervention.