Q: I’m not clear on how electronic money could eliminate inflation. Would you explain this to me? Thanks!
A: Electronic money eliminates the zero lower bound on the nominal interest rate. The reason central banks (Fed, ECB, …) have chosen 2% as their long run inflation target instead of zero is because they are worried about the zero lower bound.
The Twitter version of the answer stimulated some discussion, which you can find storified here. The opening monologue to that discussion is also copied out below:
- W or w/o depreciating currency, e-money eliminates the zero lower bound…
- The main reason many central banks (Fed, ECB …) have a long-run inflation target of 2% instead of 0 is b/c they’re worried about the ZLB.
- So if the zero lower bound is eliminated by electronic money, I predict central banks will choose a long-run inflation target of zero.
- With electronic money (think reserves, bank accounts, …) as the unit of account, depreciating paper currency makes the ZLB non-binding.
- Having the same central bank with authority to issue both e-money and currency means the exchange rate between them is fully defensible.
- So a central bank with the needed legal authority can announce a track for the exchange rate between e-money and paper money.
- Announcing a track for the e-money/paper money exchange rate that has paper money depreciating gives paper money a rate of return below zero
- Just choose a rate of depreciation of paper money relative to e-money that makes its ROR less than Fed funds target & interest on reserves.
- When the Fed funds rate target is positive, paper money can appreciate relative to e-money until it returns to par.
- If inflation is zero, to be able to continue to return to par, what is needed is for the real interest rate to be positive on average.
- Or say the health of the banking system required Fed funds rate to be at least 2% above the ROR of currency, avg r > 2% allows return to par