A central bank digital currency (CBDC) would not merely add a new payment instrument; it would alter the plumbing through which monetary policy reaches the economy. Research from the Federal Reserve and the European Central Bank converges on a central finding: the effects hinge less on whether a CBDC exists than on how it is designed. An interest-bearing CBDC with no caps could compete directly with bank deposits, tighten bank funding and raise the risk of runs, while a calibrated, capped design could leave the transmission of policy largely intact and even sharpen policymakers' view of stress as it builds.

Introduction: Understanding CBDCs and Monetary Policy

Academic work by Binghui Wu and Mengjiao Zhang frames CBDC issuance as a structural event: its issuance and circulation change the existing monetary hierarchy and monetary system. Building a dynamic stochastic general equilibrium model with households, manufacturers, government and the central bank, they examine how a CBDC affects the effectiveness of both quantity-based and price-based monetary policies — that is, the two broad families of tools central banks use to steer the economy.

The Federal Reserve's January 2022 discussion paper on the U.S. dollar in the digital age makes the same point from an institutional angle: a CBDC could fundamentally change the structure of the U.S. financial system, altering the roles of the private sector and the central bank. Neither analysis describes an operating, large-scale retail CBDC in a major economy; both rest on models and scenario reasoning, which is why design discussion dominates the literature rather than observed performance.

Balance Sheet Mechanics: CBDC's Impact on Commercial Banks

The mechanism begins with substitution. Banks currently rely, in large part, on deposits to fund their loans, and the Federal Reserve notes that a widely available CBDC would serve as a close — or, if interest-bearing, near-perfect — substitute for commercial bank money. When households convert deposits into CBDC, the aggregate deposit base shrinks, banks face higher funding expenses, and credit availability can fall or credit costs rise for households and businesses.

But the ECB cautions against assuming the direction of the flow is automatic. Its work on CBDC and monetary policy implementation argues that while a retail CBDC could change the volume of customer deposits and, in turn, central bank reserves, it is by no means clear cut that deposits would decrease; they could even increase. If deposits do fall, banks would need to draw on — and therefore reduce — their reserve holdings at the central bank, which is where monetary policy implementation enters the picture.

Monetary Policy Transmission and Central Bank Reserves

Reserves are the raw material of modern policy implementation: central banks steer short-term market rates by managing the reserves the banking system holds. A large migration of deposits into CBDC would therefore not just squeeze individual banks; it would reshape the composition of the central bank's own liabilities and the operational framework through which it controls rates.

The ECB's analysis of its own balance sheet distinguishes scenarios sharply. A pure exchange of banknotes for CBDC — cash users simply switching form — has no further implications for the central bank's balance sheet, financial risks, profits or capital. Significant CBDC volumes that replace bank deposits rather than banknotes are another matter, with a range of possible outcomes for profitability. And the ECB warns that a more fragile conventional banking sector could deteriorate the credit risk profile of counterparties to central bank operations — one reason central banks such as the ECB have built safeguards into their CBDC designs.

Key Design Choices and Their Implications

Remuneration is the pivotal choice. The ECB notes that if a central bank — contrary to its current plans — decided to use remunerated CBDC as a novel instrument to steer monetary policy transmission more directly toward households, and designed it so the effect could be material, the impacts on the financial system, particularly on commercial banks, would need careful monitoring given the lack of experience with this new transmission channel.

Holding limits work in the opposite direction: capping how much CBDC any holder can keep constrains total demand, limiting the flow that could drain deposits. The Office of Financial Research adds a subtler information argument: a CBDC used less in normal times would have a smaller impact on banks' maturity mismatch but would provide more precise signals in periods of financial stress. In other words, a modest CBDC footprint is not just safer — it makes the instrument a sharper crisis indicator.

Navigating Trade-offs: A Decision Framework for CBDC Design

The matrix below maps the supported design choices to their consequences for policy transmission and financial stability. Reading across each row shows the same underlying lever — how attractive and accessible the CBDC is relative to bank deposits — pulling two objectives in opposite directions.

CBDC design choices: monetary policy and financial stability trade-offs
Design choiceImpact on monetary policy transmissionImpact on financial stability
Interest-bearing (remunerated) CBDCCould become a novel instrument steering transmission directly toward households, but with material effects on banks and no operational track record.Remuneration makes CBDC a more attractive alternative to deposits, increasing disintermediation risk — severity depends on the remuneration level and overall attractiveness relative to bank deposits, especially under stress.
Holding limits imposedConstrains overall CBDC demand, limiting effects on the central bank's balance sheet and preserving traditional policy channels; limits require careful calibration.Mitigates run risk by restricting how much can be rapidly converted from bank deposits; a CBDC used less in normal times also yields more precise stress signals.
No holding limitsCould enable significant deposit-to-CBDC shifts, altering bank funding structure and interest rate policy effectiveness, potentially forcing adjustments to the central bank's operational framework.Enables rapid, large-scale conversion of deposits into risk-free central bank money during stress, increasing the likelihood and severity of bank runs.

The matrix shows that remuneration and holding limits jointly determine the degree of bank disintermediation, the resilience of policy transmission and the potential for instability. Notably, a small CBDC footprint — achieved through limits and restrained remuneration — preserves both stability and the informational value of the instrument, which is why the Office of Financial Research concludes policymakers must balance these competing concerns to design a CBDC that enhances rather than weakens financial stability.

Strategic Design for CBDC: A Path to Stability and Effective Policy

Policymakers considering a CBDC must strategically design its features, particularly remuneration and holding limits, to manage the inherent trade-offs between enhancing monetary policy effectiveness and preserving financial stability. The framework above makes the decision boundary explicit: every step toward a more attractive, unlimited CBDC strengthens it as a policy instrument and simultaneously strengthens it as a competitor to bank deposits.

The observable signal for successful implementation will be the stability of commercial bank deposit levels and funding costs, alongside the continued effectiveness of the central bank's primary interest rate tools, as monitored through financial market indicators and bank balance sheet data. If deposits, funding spreads and money-market rates hold steady after a CBDC's introduction, the design has struck the balance; rapid deposit outflows or rate-control difficulties would indicate the caps and remuneration settings need recalibration.

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