E-Money: Efficiency, Stability and Optimal Policy

What makes e-money more special than cash? Is the introduction of e-money necessarily welfare enhancing? Is an e-money system necessarily stable? What is the optimal way to design an efficient and stable e-money scheme? This paper provides a first attempt to develop a micro-founded, dynamic, general-equilibrium model of e-money for investigating these policy issues. We first identify some superior features of e-money which help mitigate informational frictions and enhance social welfare in a cash economy. A model that features both trading frictions and two-sided platforms is then built and used to compare two potential e-money schemes: (i) public provision of e-money with decentralized adoption, and (ii) private monopolistic provision of e-money. We show that, in general, both public and private provision of e-money are inefficient, and we characterize the optimal incentive scheme by addressing four potential sources of inefficiency – market powers in goods trading, network externality, liquidity constraint and monopoly distortion in e-money issuance. We show that the welfare impact of e-money depends critically on whether cash is a viable alternative to e-money as a means of payment. When it is not (e.g., for online payments where usage of money is prohibitively costly), the adoption of e-money is always welfare enhancing, albeit not welfare maximizing. However, when cash is a viable alternative (e.g., in a coffee shop), introducing e-money can sometimes reduce social welfare. Moreover, a system with public provision and decentralized adoption is inherently unstable, while a planner or a private issuer can design a pricing scheme to restore stability. Lastly, we examine an alternative e-money scheme – a hypothetical set-up with public provision through a private platform. We also compare the impact of various provision schemes on central bank seigniorage income. While this scheme may or may not improve efficiency, it can always increase seigniorage income, even though there may exist better policy options such as imposing a cash reserve requirement or collecting a charter fee.