Monetary Policy, Monetary Areas, and Financial Development with Electronic Money

Contributor Notes

Author’s E-Mail Address: MArnone@imf.org, LBandiera@worldbank.org

Electronic money (e-money), as a network good, could become an important form of currency in the future. Such a development could affect monetary policy effectiveness. If an increased use of e-money substantially limits the demand for central bank reserves, this limitation would require changes in the central bank operational target and a closer coordination of monetary and fiscal policies. Also, the optimal size of monetary unions would be different. However, the current level of e-money use does not seem to pose a threat to the stability of the financial system. Thus, central banks can successfully implement the objectives of monetary policy.

Abstract

Electronic money (e-money), as a network good, could become an important form of currency in the future. Such a development could affect monetary policy effectiveness. If an increased use of e-money substantially limits the demand for central bank reserves, this limitation would require changes in the central bank operational target and a closer coordination of monetary and fiscal policies. Also, the optimal size of monetary unions would be different. However, the current level of e-money use does not seem to pose a threat to the stability of the financial system. Thus, central banks can successfully implement the objectives of monetary policy.

Introduction

The recent evolution of the technology for financial transactions poses interesting questions for policymakers and financial institutions regarding the suitability of the current institutional arrangements and the availability of instruments to guarantee financial stability, efficiency, and effectiveness of monetary policy. The aim of this paper is to dispel some of the most extreme predictions.

The disappearance of money, central banks made redundant, monetary policy made irrelevant are not logical impossibilities, but extreme events. It is not impossible to envision a world with these most extreme characteristics (King, 1999) and to describe its functioning in the new setup, but how likely are these events to occur? The view that they will happen in the foreseeable future cannot be shared. From an operational point of view, we need to ask whether the actual institutional arrangements can respond properly to the recent wave of financial infrastructure innovations and if their policy instruments are still viable.

Regulatory concerns are raised by internet banking, electronic finance (e-finance), and e-money but are not addressed in these notes. Here the focus is primarily on the forces sustaining the development of e-money and on the central bank ability to conduct monetary policy in the presence of e-money.2

This paper argues that e-money, as a network good, could become an important form of currency in the future. Such a development would influence the effectiveness and implementation of monetary policy. If an increased use of e-money substantially limits demand for central bank reserves, it would require changes in the operational target of the central bank and a closer coordination of monetary and fiscal policies. The optimal size of monetary unions could differ should e-money play a prominent role.

However, the current level of e-money use does not pose a threat to the stability of the financial system, and central banks have the means to successfully implement the objectives of monetary policy.

With respect to the current debate on the consequences of the introduction of e-money on the implementation of monetary policy and in contrast with earlier work on this topic (Freedman, 2000; Friedman, 2000; Goodhart, 2000; and Woodford 2000), this paper argues that central banks can lose control over monetary policy if the government does not run a responsible fiscal policy. Central banks could react to this threat by introducing additional regulation or by resizing the monetary areas which they ought to regulate, as we shall argue in later sections.

This paper is structured as follows. Sections II and III describe e-money and its characteristics as a network good. Section IV analyzes payments and settlement issues. Financial development issues are discussed in Section V, while Section VI describes the transmission mechanism of monetary policy in the presence of e-money. Section VII redefines the optimal size of monetary areas, and Section VIII concludes.

II. Definition and Classification of E-Money

E-money is defined as an “electronic store of monetary value on a technical device that may be widely used for making payments to undertakings other than the issuer without necessarily involving bank accounts in the transaction, but acting as a prepaid bearer instrument” (ECB, 1998). There are three main types of e-money: e-cash, network money, and access products. E-cash includes reloadable electronic purses and multi-purpose stored value cards.3 Network money defines funds stored in software products that can be used for payments or transfers over communication networks (i.e., the Internet). Access products allow agents to access their bank accounts and transfer funds (Prinz, 1999). These latter products are new ways of executing transactions with existing forms of money (OECD, 2002).

E-money schemes have some distinguishing features: (i) technical implementation requires computer and software expertise; (ii) these products are liabilities on the balance sheet of the issuer;4 (iii) transferability is somehow limited: while relatively straightforward from consumer to merchant, to be redeemed by the issuer, it is unusual from consumer to consumer (peer-to-peer); and (iv) transactions can be easily recorded (no anonymity).5

Some schemes allow spending e-money on a single good or service, others on a set of goods and services (multi-purpose e-money). Technology clearly leans in the direction of expanding the set of goods and services that agents can purchase within the same scheme. Schemes can involve two parties, where the issuer of e-money is also the provider of goods and services; or schemes can involve three parties, where the issuer and provider functions are separate.

There are several characteristics that distinguish e-money from traditional bank notes. The latter are infinitely transferable and completely anonymous, totally risk-free from a settlement point of view, and can be used for any sort of transaction without restrictions, since bank notes are legal tender. Traditional bank notes have the maximum benefit from positive network externalities, as we shall see in Section III. E-money is not a liability necessarily settled on the books of the central bank. For this reason e-money exploits network externalities to a much more limited extent, depending on the size of the scheme (number of goods and services offered, number of people using the scheme, ease of access, and so forth).

In assessing e-money as a network good (see Section III) vis-à-vis government money, the following elements could also be considered: (i) transaction costs tend to be higher compared with traditional bank notes, as e-money requires specific technologies; (ii) the potential effects of taxation could include an ex ante reduction on the use of private money; (iii) collection of seigniorage (or other forms of revenues) would be internalized by the issuing network; (iv) interest sensitivity to other forms of interest-bearing assets in the context of a multiplicity of competing monies and asset substitutability; and (v) expectations and risks regarding alternative monies.

The Bank for International Settlements (BIS) regularly surveys the development of e-money. Since 2000, annual statistics have been compiled (Tables 1 and 2). The last survey covers the period from 2002 to 2003. Even though the time period covered by the surveys is limited, a few general conclusions can be drawn on current trends in e-money developments. E-money products are generally card-based; however, the network-based systems’ growth rate has been 100 percent and 67 percent in 2001 and 2002, respectively, compared to 27 percent and 36 percent, respectively, in card-based systems (Figure 1). They can be used to execute a multiplicity of payments, and most of them are adapted for network payments. The direct transferability of funds among users is limited, as is the possibility to use e-money for international transactions (Tables 3 and 4).

Table 1.

System Design Features

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Source: Bank for International Settlements (2000, 2001a, and 2004).

“-” indicates either that a system has been discontinued before the survey or that the sytem has not been launched yet.

Table 2.

Data on Use of E-Money

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Source: Bank for International Settlements (2000, 2001a, and 2004).

“-” indicates either that a system has been discontinued before the survey or that the sytem has not been launched yet.