Core Focus: The potential for CBDC to enable effective negative interest rate policies by overcoming the zero lower bound constraint imposed by physical cash.

In-Depth Notes:
One of the most significant potential applications of CBDC is the ability to implement effective negative interest rate policies (NIRP). The zero lower bound (ZLB) exists principally because negative returns can be avoided by switching from holdings to physical cash, which is a zero-interest bearer instrument . Digital currency overcomes the ZLB limitations inherent in physical cash, allowing the central bank’s policy toolkit to incorporate NIRPs .

The Cash Constraint Problem:
Physical cash has traditionally imposed a constraint on how low interest rates can go. If a central bank sets a negative policy rate, depositors can simply withdraw their funds as physical cash and hold it at zero return, avoiding the penalty. This “cash constraint” limits the effectiveness of negative rates. CBDC, by replacing or complementing cash, removes this constraint. Since CBDC is digital, the central bank can impose negative rates on CBDC holdings, making it costly to hold large digital balances and thereby encouraging spending and investment.

CBDC as a Tool for NIRP:
CBDC can be used alongside the abolition of cash to help implement negative interest rate policies. Research using a two-period OLG model including competitive firms, monopolistic banks, and a central bank has found that CBDC can overcome the effective lower bound and achieve negative interest rate monetary policy . The introduction of CBDC can effectively increase the money supply in the market and stimulate economic activities, so as to overcome the zero lower bound on interest rates . CBDC can be used as an effective tool to help the central bank expand domestic demand, stimulate economic activities, and promote a virtuous cycle of the economy .

Critical Perspectives on NIRP:
However, the effectiveness of NIRP is not without debate. A NIRP is a tax in sheep’s clothing, and empirical evidence to date suggests that such policies do not stimulate the economy . This perspective highlights the potential downsides of negative rates, including the risk of damaging bank profitability and the potential for unintended behavioral responses. Research on the digital euro specifically has found that NIRPs will be more limited in the case of the introduction of CBDCs. The introduction of the digital euro could potentially move the effective lower bound (ELB) from its current value of around −1.30% by approximately 0.25% . This suggests a meaningful but not revolutionary impact on the ability to implement negative rates.