Money Supply and Monetary Economics

Money Supply and Monetary Economics

• Studying monetary economics begins with understanding the definition of money, as it is not possible to understand how central banks can impact prices and economic activities without defining money.
• This chapter focuses on the supply of money by central banks and how it is transmitted to the broader economy via the money market.
• A focus on different forms of money and retail digital currencies are key, and to monitor and analyze changes in central bank money supply, and understand the process of money creation by the banking sector.
• Money supply and demands shocks impact the money market equilibrium.

Defining Money

• A solid understanding of the different functions of money and their relation to the fiat money system is needed.
• Discussions on central bank digital currencies (CBDCs) are prompted by the increasing availability of digital forms of private money
• Economists define money as anything accepted as payment for goods, services, or debt repayment, a broader definition.
• Assets easily and costlessly transformed into currency or checking accounts are considered money.
• Financial innovation causes variations in asset classifications that fall under money, making measurement challenging
• Data series of money aggregates are constructed to measure the stock of money in an economy.
• Base money and commercial bank money are the two types of money
• The central bank has full control over the supply of base money, therefore eventual money creation is only partly controlled by the central bank
• Financial institutions have an important role in creating money and credit
• Distinctions exist between control over the total money supply versus control over the monetary base, and the banking sector plays a role in determining the supply of money.
• The most common interpretation of money is currency, including paper bills and coins but money has taken different forms over time
• Government-controlled (sovereign) currency, or fiat money, is currently the universally accepted means of exchange.

Functions of Money

• Money traditionally has three functions: a unit of account, a medium of exchange, and a store of value
• Unit of account: Money helps communicate value by allowing the price of each good or service to be tracked in units of money instead of relative to each other
• Medium of exchange: Money allows efficient exchange, facilitating trade even without a "double coincidence of wants"
• Store of value: Retaining its value allows the receiver to pay for a future good or service of similar value at some point in the future

Fiat Monetary System

• The current monetary system uses government-controlled fiat money.
• Fiat money refers to currency with no intrinsic value designated as legal tender by a government.
• This system contrasts with historical commodity standards where currency issuers maintained a fixed exchange rate with commodities
• Currencies are no longer commodity-backed, and the government holds the money supply monopoly
• Central banks issue physical currency and allow commercial banks to hold deposits, which are called central bank reserves
• The currency in circulation along with deposits held at the central bank make up the monetary base.
• Private banks act as money issuers with a legally binding commitment to full convertibility of bank deposits.
• Physical cash, reserves, and bank deposits are all part of the fiat currency system with full convertibility of bank deposits to an equal quantity of the corresponding government-issued fiat currency.

Digital Currencies and CBDCs

• The availability and usage of digital currencies have rapidly evolved.
• Digitalization is causing a shrinking role for physical cash and a increasing new digital forms of money
• These cause a debate about the potential need for central bank digital currencies (CBDCs)
• Digital money is commercial bank money and transactions having been digital for years, and central banks provide wholesale digital money to commercial banks
• A retail CBDC is dominantly seen as a form of public "digital cash" available to households and/or non-financial companies.

Declining Cash Usage

• Cash is still the most used means of payment for paying at the point of sale, with 52% of point-of-sale (POS) transactions in 2024
• 59% in 2022, 72% in 2019, and 79% in 2016 were the rates for previous years for cash use for payments at point of sale
• Most POS payments are made in cash in some countries, such as Malta at 67% and Spain at 53%
• Most frequent card payments are in Finland at 57% and France at 48%
• Of all non-recurring payment transactions in 2024, 75% were POS, 21% online and 4% person-to-person (P2P)
• Online payments in euro area consumers' day-to-day purchases have increased, accounting for 7% in 2019, 17% in 2022 and 21% in 2024
• In terms of value, the share of online payments was 36% in 2024, compared with 18% in 2019 and 28% in 2022.
• The share of cash payments at POS for the euro area was 45%, larger than cash payments (39%) in value terms.
• The share of card payments in 2024 was one percentage point lower than in 2022, indicating potential payment method stability.
• Euro countries have generally witnessed a decline in cash use over time in terms of the number of POS transactions.
• Finland and the Netherlands actually recorded the lowest proportions of cash payments in POS transactions at 27 and 22%

Preferred Payment Methods

• Cash remains the most frequently used means of payment in person-to-person (P2P) transactions in the euro area (41% compared to 36% for payments with cards and mobile apps)
• In 2019 use of physical PP2P payments were 86%, 73% in 2022 and 63% in 2024 for a subgroup of data that constituted 65% of all P2P payments in 2024
• There is still a considerable preference for cash from 10% in Finland to 38% in Austria even for what payment methods people had a perference
• Most people prefer to use card or other cashless means of payment, varying from 39% in Austria to 76% in Finland.
• Almost two-thirds of respondents still wished to keep cash as a payment option, showing the importance of different payment options

Digital Currency Implications

• The emergence of digital currencies is transforming payment systems
• Digital currencies unbundle money's functions due to digital networks, which lowers switching costs and reduces network externalities
• Lower switching costs and reduced barriers increase currency competition, allowing currencies to specialize in certain roles.
• Money re-bundling occurs due to digital platform, where currencies differentiate based on monetary and platform features
• Platforms offer new features so user preferences for currencies may vary
• Issuers are incentivized to create differentiated products, leading to segmented markets focusing on different user types
• The organization of the financial system has payment services traditionally offered by banks being transferred to the entities that run the digital platforms
• Credit card companies and banks may lose their ownership of transaction data may shift to digital platforms
• Clear benefits of efficiency in competition and payment protocols
• Platforms are incentivized to be closed ecosystems, leading to monopolies and fragmented markets
• Policymakers need to take regulatory actions related to data usage, storage, and interoperability, also accessibility, safety and soundness

Central Bank Digital Currencies (CBDCs)

• Private digital currency innovations and forms stimulated central banks to investigate the impact and potential role of CBDCs
• A CBDC is the “digital representation of a sovereign currency issued by and as a liability of a jurisdiction's central bank or other monetary authority”
• A CBDC is the digital equivalent of physical cash
• Adrian & Mancini-Griffoli (2021) created a taxonomy called the Money Tree
• Five types of money can be distinguished based on central banks’ features, along with:
  • Central bank money
  • Cryptocurrencies
  • b-money (bank-issued)
  • e-money (private sector providers)
  • i-money (investment money)
• The types are distinguished by their object or claim type, value (fixed or variable), backstop (government or private), and degree of centralization in technology
• Cash is a form of object-based payment
• B-money is the most used type of claim-based money and is backed by a government guarantee
• A CBDC is a digital counterpart, cryptocurrencies are a digital means for object-based based on blockchain technology
• E-money is similar to b-money but with the guarantee provided by private parties instead of a governmental entity
• I-money offers variable-value redemptions into currency
• Crypto currencies show excessive volatility in their value in terms of fiat currency
• Excessive volatility is too high for cryptocurrencies to be an important means of payment. It could be a store of value, however the medium of exchange function is challenging
• E-money and i-money are seen to have the potential to be more disruptive than crypto currencies due to the perceived stability of value
• Adrian & Mancini-Griffoli (2021) noted in their IMF Fintech note that 90 percent of Kenyans over age 14 paid with M-Pesa, while the value of e-money transactions in China, such as with WeChat Pay and Alipay, surpassed those of Visa and Mastercard combined worldwide. M-Pesa is dominant in Kenya and over 90% market share in China

E-Money Popularity

• E-money's popularity comes from convenience, user-centered design, speed, and affordability.
• E-money transfers are cheaper and faster than card or bank transfers for cross-border payments, and network effects boost adoption.
• In China Alipay and WeChat Pay are liabilities are fully covered, meaning their client funds are held at the central bank in the form of reserves. They also integrate financial and commercial ecosystems on top of classic e-money wallets.
• Kenya's M-Pesa is legally bound to back their e-value with bank balances at commercial banks through trust accounts, where The Kenya Deposit Insurance Corporation provides pass-through coverage in case of the default of the deposit-taking commercial bank holding the trust accounts
• Privately-issued e-money enhances financial inclusion in developing countries, with options to open mobile money accounts linked to their phone numbers, which increases access to finance even for the unbanked

Central Bank Motivations for CBDCs

• Universal goals include financial inclusion, also universal access to public money
• CBDC's may act to safeguard or achieve universal access to payments when there is a declining cash use or access to cash services
• Extreme circumstances can take the form of destructions to financial and physical infrastructure but also to disruptions in the digital infrastructure
• A CBDC is then considered to provide a (potentially non-digital) fallback system in case of system failure to existing digital payment solutions, especially in the absence of physical cash as a backup, allowing for increased payment system Resilience
• CBDCs secure monetary sovereignty in a digital economy, in case new forms of private digital currencies have competitive advantages relative to the traditional sovereign currency
• CBDCs can strengthen the role of the sovereign currency as anchor for domestic payments.
• CBDCs can help to foster competition by offering a direct, risk-free, digital standard that is an outside option for depositors
• CBDCs can facilitate convertibility among private digital currencies and lower entry barriers for new firms that should counteract segmentation in the payment landscape due to network effects and/or commercial strategies.

Concerns with CBDCs

• Stablecoins, which gives rise to financial stability concerns have direct connections to the financial system via their reserve assets
• Large-scale redemptions or could destabilize the financial market, but does not call for the launch of a CBDC.

Unilateral vs Intermediated CBDCs

A choice should be made between a unilateral (direct) CBDC or an intermediated CBDC to launch a CBDC A unilateral CBDC has the central bank being the major operator and carring out all the functions, such as issuing the CBDC, distributing it, overseeing the validation of transactions and the updating of the ledger, and even interacting with the end-users, of retail payments, accounts, and transactions involving the CBDC. Intermediated CBDCs are where commercial banks issue it Intermediated CBDCs involve the central bank continuing to issue it, but only to other intermediaries Users would not hold central bank money then, hold claims against their bank in CBDC form. Functions are conducted by financial firms "Hybrid" models involve private intermediaries executing interactions with other users such as onboarding and compliance. The CBDC also remains on the central bank book

CBDC's Design Features

• Efficient technology to be considered reliable and simple to use as well guaranteeing large anonymity
• Facilitation of off-line capacity is often mentioned to add to an increased resilience of the payment system and to benefit financial inclusion and universal access to payments
• Awareness has grown over cross-border implications if CBDC’s have high international payments and international collaboration is required to find ground in this matter

CBDC risks

• Potential negative impact of a launch of a CBDC on the banking sector, since a CBDC might lead to losses of deposits for banks to the extent that depositors switch from commercial bank deposits to the CBDC
• By competing with bank deposits as a payment instrument, a CBDC could increase commercial banks' funding costs because and would force them to increase their deposit interest rates and increase lending which would decreases loan availability

Burlon et al. (2024):

• Examined the effects of introducing a digital euro and estimated the effects of it happening to the banks stock prices
• Stock price changes around such news events can reflect perceived impact of the digital euro on bank profitability.
• The banks' abnormal returns associated with digital euro news are estimated using a Fama and French (1993) three-factor model
• Adverse market assessment of the prospects of a bank in a world with a digital euro may translate into more expensive market-based funding options for that bank
• There may be scope for data being non-public of from AnaCredit

Other CBDC Implications

• Market participants may expect a significant impact of a CBDC which impacts banks' valuations based on reliance on a funding deposit Restrictions may need to be made on competition from bank deposits, leading to limits/zero remuneration of CDBC
• Results are that between 15-45% of real GDP has positive welfare effects in restricting the amount of digital currency
• The introduction did not necessarily decrease bank disintermediation and can expand it if interested rates are kept in range
• To prevent high interest rates you need active banks
• Monetary policy can have easier implentation ensuring monetray soverginty by accessing more granular payment data
• However balancing privarcy concerns with regulatory safeguards is important Monetary policy can transmit easier by
• Strengthening cost of capital channel Increasing bank lending channel

CBDCs Alternative Routes

• Existing systems can improve with technology
• Prominent examples of innovations are payment systems and touch less cards
• Adequate regulation
• Regulation can contain risks of e and i money without using CBDCs
• Risks that can be prevented are a collapse of currencies or if monopolistic forms can be prevented with regulation

CBDC Future Outlook

• The most recent BIS survey on CBDC held in late 2023 reflects that most central banks (94% of the 86 central banks) are working on CBDC projects (most both on wholesale and retail CBDC
• The share of central banks that are likely to issue a retail CBDC is around 12%
• In general terms they see:
• A CBDC that is subject to holding limits
• Is interoperable with their domestic payment systems
• Enables offline payments
• It can be used without a bank account and may require merchants to accept it

CBDC Example Projects

• Riksbank's e-krona project however it was reported in 2023 that the Riksbank has stopped in issuing this
• China's digital yuan has been piloted and adopted into 29 cities
• Bahamas' Sand Dollar one-to-one backed to it, pegged to the US dollar