Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Are Testing Digital Currencies
Transcript
- Lucas: Over the past year, central bank digital currency pilots have gone from niche experiments to something close to mainstream. China's digital yuan alone has reportedly been used in over 200 million wallets as of mid-2026. Luna: That is a staggering number. And it's not just China — the European Central Bank is deep into its digital euro project, Sweden's e-krona is in its third phase, and even the Bahamas has had the Sand Dollar for a few years now. Lucas: Exactly. According to the Bank for International Settlements, over 90 percent of central banks globally are actively exploring some form of digital currency. The question is no longer whether CBDCs are coming, but how they'll change the way monetary policy works. Luna: And that's the angle most business news misses. They talk about the tech, the privacy debate, the potential to replace cash. But what does a CBDC actually mean for the tools central banks use every day? Lucas: Right. So let's start with the transmission mechanism. In a traditional system, a central bank changes the policy rate, that feeds through to interbank rates, then to lending rates, then to consumption and investment. It's indirect and it has lags. Luna: And with a CBDC, the central bank could theoretically adjust the interest rate on the digital currency itself — making it a direct tool for influencing saving and spending. Lucas: Precisely. If the central bank wanted to stimulate the economy, it could lower the rate on CBDC holdings, even push it negative. That's something you can't do with physical cash easily. A CBDC removes the zero lower bound constraint completely. Luna: That seems like a huge deal for countries that have struggled with low inflation and near-zero rates — Japan, the Eurozone. But doesn't it also raise the risk of bank runs? If people can instantly convert deposits into central bank digital money during a panic. Lucas: That is the single biggest financial stability concern. A CBDC could be a perfect substitute for bank deposits, especially if it's insured or perceived as safer. During a crisis, you could see a flight from commercial bank deposits into the central bank's digital wallet. Luna: And that would starve banks of funding, potentially triggering a credit crunch. So central banks are thinking hard about design features to prevent that — like holding limits, tiered remuneration, or interoperability with the banking system. Lucas: China has capped individual digital yuan holdings at around $1,400 equivalent. The ECB is reportedly considering a similar cap for the digital euro. The idea is to keep CBDCs a medium of exchange, not a store of value that competes with banks. Luna: But if you cap it, doesn't that limit the monetary policy potential? If the central bank wants to use the CBDC rate to influence behavior, but only a small amount of money is in CBDC form, the tool is less powerful. Lucas: That's the trade-off. Some economists argue that for monetary policy transmission, a more elegant approach is to use the CBDC as a kind of 'pass-through' mechanism. The central bank adjusts the rate banks earn on reserves, and that automatically passes through to the CBDC rate — which then guides the deposit rates banks offer. It's a way to strengthen the transmission without replacing banks. Luna: So it's more about removing frictions. Like, if the central bank cuts rates, banks follow faster because customers can easily move money into the CBDC if their bank's deposit rate isn't competitive. Lucas: Exactly. That's the vision. But the BIS and many central banks are also looking at data. A CBDC could give central bankers real-time, anonymized data on aggregate spending patterns. That could revolutionize how they estimate inflation, output gaps, and even the effectiveness of policy moves. Luna: That raises huge privacy questions. Are we comfortable with the central bank seeing every transaction? Even if it's anonymized, the level of surveillance is unprecedented. Lucas: And that's why the debate is so polarized. The design choices — who can see what, under what conditions — will define public trust. The Swedish Riksbank, for example, has emphasized that its e-krona would not be a surveillance tool, and the platform would be designed to minimize data collection. Luna: But if you want the monetary policy benefits, you need granular data. Otherwise you're just moving digital cash around without the analytics. Lucas: Right. So there's a spectrum: some central banks are pushing for what they call 'programmable money' — where the digital currency could be restricted to certain uses, like only for food purchases during a crisis. That's a huge step beyond just a digital version of cash. Luna: And that gets into the political realm very quickly. Should a central bank have the power to dictate how people spend their money? Even in an emergency, that's a slippery slope. Lucas: It is. And that's why the current wave of pilots — particularly in China and Sweden — is so important. They're testing not just the technology, but the social and political boundaries. Luna: Speaking of testing, let's talk about the Bahamas for a second. The Sand Dollar is the world's first fully launched retail CBDC. Has it actually changed monetary policy in any meaningful way? Lucas: Not dramatically, because the scale is small. But one thing it has done is improve financial inclusion. In the outer islands, where banks are scarce, people can now use the Sand Dollar via a mobile wallet. That expands the monetary policy reach — if people are unbanked, they're outside the transmission mechanism. Luna: So CBDCs could be a way to bring more people into the formal financial system, which strengthens the central bank's ability to steer the economy. Lucas: Exactly. And that's one reason the IMF and World Bank have been supportive. But there are risks — if the system is hacked, or if people lose confidence, a digital run could be much faster than a physical one. Luna: So while the potential for monetary policy is exciting, the operational risk is sobering. Central banks are famously risk-averse. The fact that we're even having this conversation means they see the benefits as outweighing the dangers. Lucas: If this deep dive into CBDCs was useful to you, these episodes stay ad-free thanks to listener support. You can contribute at buy me a coffee dot com slash fexingo. Luna: Yeah, it really helps us keep doing these detailed, nuanced takes without any sponsor pressure. Lucas: So back to those risks — beyond the financial stability and privacy issues, there's also the question of monetary sovereignty. If a foreign country's CBDC becomes widely accepted in your economy, you could lose control over your own monetary policy. Luna: That's the 'digital dollarization' risk. If the digital euro is easy to use in, say, Eastern European countries with weaker currencies, those countries might see a shift away from their own currencies. Lucas: Right. And that's why many central banks view CBDCs as a defensive move. It's not just about efficiency — it's about maintaining control in a world where private cryptocurrencies and foreign digital currencies could erode their ability to set interest rates and manage the economy. Luna: So it's a bit of an arms race. The Fed has been relatively cautious compared to China or the ECB. But as of mid-2026, the Fed has been actively researching a digital dollar, even if they haven't committed to launching one. Lucas: The Federal Reserve is in a unique position because the dollar is already the global reserve currency. They don't face the same urgency. But if the digital euro proves popular internationally, that could change the calculus. Luna: And don't forget the private sector — stablecoins like USDC and USDT are already being used for payments. If they become dominant, central banks might lose their monopoly on the final settlement asset. Lucas: That's a key point. A CBDC is ultimately about preserving the role of central bank money in the digital age. If people start using a private stablecoin for everyday payments, the central bank's ability to implement monetary policy deteriorates. Luna: So what's the timeline? When will we see a major economy's CBDC widely adopted for daily use? Lucas: The digital yuan is already used in dozens of Chinese cities, but it's still not a full replacement for cash or WeChat Pay. The ECB aims to make a decision on a digital euro by 2028. Sweden is similar. So we're probably looking at the early 2030s before a major central bank fully launches a retail CBDC. Luna: That gives us time to get the design right, but also time for the risks to become clearer. Lucas: Exactly. And one thing is certain: the monetary policy toolkit of 2040 will look very different from today's. CBDCs are likely to be a core part of it.