Managing Aggregate Liquidity: The Role of a Central Bank Digital Currency∗

We study how the introduction of a central bank-issued digital currency affects interest rates, the level of economic activity, and welfare in a model where both central bank money and private bank deposits are used in exchange. Banks in our model are financially constrained and the liquidity premium on bank deposits affects the level of aggregate investment. We study the optimal design of a digital currency in this setting, including whether it should pay interest and how widely it should circulate. We highlight an important policy tradeoff: while a digital currency tends to promote efficiency in exchange, it also crowds out bank deposits, raises banks’ funding costs, and decreases investment. Despite these effects, introducing a central bank digital currency often raises welfare.