On the Essentiality of Electronic Money∗

What makes e-money special relative to cash? How does the introduction of electronic money improve the functioning of a payment system, in which cash is used as an incumbent payment instrument? This paper adopts a mechanism design approach to identify the essential features of e-money that improve the effi ciency of the economy. We build a micro-founded general equilibrium model to compare the effi ciency properties of different payment systems. We start with a basic environment in which traditional cash is used as a payment instrument. We then gradually attach additional features to this payment instrument, including some distinctive characteristics of electronic money. We identify several features of e-money which can help mitigate fundamental frictions and enhance social welfare in a cash economy. Our findings help clarify how e-money can be an essential component of a payment system (even in the absence of other transactions cost advantage over cash), and provide guidance on the design and regulation of e-money products.