## wp18191

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---

### I. Introduction and context
- The global financial crisis brought policy rates to the so-called zero lower bound (ZLB) in many countries; "Some countries are still at this lower bound ten years after, and others are very close."
- Larry Summers warned central banks may not have sufficient policy space to counter the next recession, noting "countries should be able to cut rates by 500 basis points" to respond to important negative shocks.
- "Figure 1 shows that all but two OECD countries have monetary policy space that exceeds 500 basis points, and only three have policy space in excess of 250 basis points."

### The lower bound and the role of cash
- The lower bound on interest rates is due to the existence of cash, which "by design yields a nominal interest rate of zero."
- If a central bank attempts to move its policy rate significantly below zero:
  - commercial banks' interest margins will be compressed unless they charge negative interest on deposits;
  - depositors may switch from (negative) interest-bearing deposits to cash, potentially causing "a substantial outflow of deposits from the banking sector."
- Substitution from deposits and reserves into cash underlies the existence of the lower bound.
- Recent experience suggests "the lower bound is somewhat below zero," because storing and handling cash involves cost and inconvenience relative to deposit accounts.
- "No large-scale substitution toward cash has been observed in connection with negative interest rates as of yet," but substitution would occur if interest rates became sufficiently negative and would erode banks’ funding base.
- Large-scale substitution into cash would undermine intended stimulating effects of deeply negative policy rates because "the zero rate on cash, and not the negative rate on central bank reserves, would become the economically relevant interest rate."

### Proposals to increase monetary policy space
- Proposals include:
  - raising the inflation target,
  - adjusting exchange rate policy,
  - conducting large scale asset purchases,
  - phasing out cash to allow for substantially negative interest rates (Blanchard 2010, Williams 2017, Svensson 2003, Ball et al. 2016 and Rogoff 2014).
- Only phasing out cash "fully removes the lower bound constraint."
- Each proposal has advantages and drawbacks and should be considered alongside alternatives.

### III. Decoupling cash from electronic money — core concept and operational design
- Core idea:
  - Split the domestic monetary base into two local currencies: cash (physical banknotes and coins) and reserves (electronic, central-bank reserves).
  - Reserves pay nominal interest, possibly negative. The overnight rate on reserves is denoted i_R_t (the policy rate).
  - Central bank sets a spot cash reserve conversion (CRC) rate for cash withdrawn from or deposited in the central bank’s reserve accounts and supplies cash fully elastically on demand against reserves at this price.
- CRC operational mechanics:
  - Banks depositing cash to reserve accounts are credited at the prevailing CRC rate (not at par); withdrawals debit reserve accounts at the CRC rate.
  - The rate of change of the CRC determines the yield on cash in terms of reserves.
  - Central bank adjusts the CRC (preferably continuously, e.g. daily) to impose a deterrent negative yield on cash in terms of reserves when reserves carry a negative interest rate.
  - The cash yield in terms of reserves is i_C_t (annualized during time units d between CRC adjustments). The CRC is defined by an expression involving i_C_t and d (as presented in the source).
  - The CRC can be set such that the negative yield on cash equals the negative interest rate on reserves, or it can deviate to steer demand for cash.
- Operational considerations:
  - Continuous (preferably daily) CRC adjustments avoid discrete wealth redistributions and speculation.
  - Central bank could announce end-of-day CRC for the following business day, or announce a path until the next policy meeting.
  - The dual local currency system could remain in place even when interest rates return positive; trade-offs include reduced seigniorage if structural shift to non-cash payments occurs.

### Numerical example (preserved exactly as in the source)
- Scenario setup:
  - Suppose a central bank moves from a zero to a negative rate of −3% p.a. on reserve accounts at the central bank.
  - To prevent hoarding, the central bank announces a dual local currency system with an initial CRC0 = 100 (defined in units of cash per 100 units of reserves).
  - The central bank sets the yield on cash in terms of reserves equal to the interest on reserves (for simplicity).
  - It announces that tomorrow’s CRC will be ܥܴܥ1 = 100.0085.1
- Evolution:
  - After a year with −3% p.a. interest on reserves, the CRC rate would be 103, and 100 units of cash would be converted into roughly 97 units of reserves.
  - Figure 4 (in source) is based on monthly CRC adjustments for illustration.
- Exit dynamics:
  - In the example, the negative interest rate is abandoned at month 13.
  - The CRC is kept at 103 for as long as the interest on reserves remains zero.
  - In month 18, central bank tightens policy to 3% p.a.; the CRC starts reversing so that the yield on cash in terms of reserves becomes a positive 3% p.a.
  - If the interest rate remains at 3%, the CRC rate returns to par in month 30; at that point the system can be safely exited.
- Notes:
  - The square root expression used in the example refers to the daily equivalent gross compound interest of a yearly interest rate of −3%, with a year defined as 360 days.
  - The central bank cannot exit by a discrete appreciation of cash to par without redistributing wealth and encouraging speculative runs into cash; exit must await the CRC naturally return to par or follow an announced path to avoid disruption.

### Foreign exchange and arbitrage implications
- Two domestic-to-foreign exchange rates would coexist: one for domestic cash per foreign currency, and one for domestic electronic money (reserves) per foreign currency.
- The central bank deterministically fixes the domestic cash–reserve exchange (CRC); the market sets the two domestic-to-foreign exchange rates.
- Uncovered interest parity (UIP) relations among the three exchange rates would be maintained when cash depreciates at the rate consistent with the negative interest rate on reserves.
- No new unlimited arbitrage opportunities arise compared to a closed economy as long as the CRC is set according to the described principles; currency controls or market rationing are not required.

### B. Transmission beyond banks
- Transmission path highlights:
  - Whether and how commercial banks pass on the CRC to customers is a business decision, not mandated by the central bank.
  - Cash handling companies and their pricing choices play a central role in transmission.
  - Symmetric application of CRC by the central bank (applying to both withdrawals and redeposits) is crucial to prevent short-circuiting the cash cycle.
- Likely pass-through dynamics:
  - For short and mild episodes of negative policy rates (e.g., below a margin of a few percentage points and within a reasonably short period), CRC pass-through to retail customers might not occur immediately because of one-off adaptation costs for banks and existing ATM unit conversion factors.
  - If banks have already incurred one-off adaptation costs, pass-through could be immediate.
  - For longer or deeper negative-rate episodes, the conversion cost becomes steep enough that banks and firms would likely pass it on; institutional non-bank firms and non-financial firms are likely to see the CRC passed on earlier than households and small enterprises.
- Cash circulation implications:
  - Banks decide whether retail customers withdraw cash at par or at CRC; shops accept cash and bring it back to banks, which would likely credit firms’ accounts at the conversion rate they face (less than par).
- Pricing and unit-of-account uncertainty:
  - Crucial unanswered question: which currency (cash or reserves) becomes the main unit of account?
  - Firms may first incentivize customers toward electronic payments (e.g., bonuses or coupons for non-cash payments) before changing posted prices.
  - If the value of cash deviates substantially from reserves, firms may choose different currencies for price quotes, causing dual nominal price paths.
  - The choice of unit of account determines whether the ZLB on cash is removed in practice (electronic currency must be the unit of account for negative reserve rates to lower real interest rates).

### IV. Issues and unanswered questions
- Implementation requires legal and financial framework changes; specifics are country- and context-specific and beyond the paper’s scope.

- A. The Unit of Account and Legal Tender
  - Money functions: means of exchange, unit of account, store of value.
  - For the dual local currency system to remove the ZLB, the electronic currency must become the unit of account; prices, wage contracts and important nominal contracts should predominantly be written in electronic currency.
  - Legal tender implications:
    - Legal tender status historically supports the unit-of-account function.
    - In most countries, cash is legal tender; central bank reserves are sometimes included.
    - Bank deposits are not legal tender; they circulate by convention and trust.
  - Options and trade-offs:
    - Revoking legal tender status of cash would deprive non-bank citizens of access to legal tender unless electronic legal tender is made widely accessible.
    - Electronic legal tender could be provided to non-bank citizens via central bank deposit and payments facilities or via bank special deposits backed by central bank reserves; special deposits could be granted legal tender status.
    - A widely accessible electronic legal tender could fundamentally alter banking structure, deposit demand, seigniorage, and credit allocation.
  - Contracts and legacy issues:
    - Essential that new contracts be written in electronic currency.
    - Legacy contracts that do not specify a means of payment pose redistribution risks: debtors could repay in depreciating cash, shifting wealth from creditors to debtors.
    - Recurrent payment contracts (mortgages, wages) are particularly problematic.
    - Transition requires legal amendments clarifying which currency contracts refer to and ensuring taxes and state contracts use electronic currency.

- B. Behavioral responses in the transition
  - Uncertainty: initial behavioral responses are unknown; public learning and financial literacy matter.
  - Risks and practical concerns:
    - Poor communication or misunderstanding could temporarily induce runs into cash (e.g., citizens might think negative-interest deposits mean they get more cash for deposits).
    - Temporary cash shortages could result; preparations should include clear communication, large cash stocks, and financial education.
    - Introduction of such a regime could signal crisis and erode trust, potentially accelerating shifts to alternative currencies (foreign currency, gold, cryptocurrency), though historical evidence suggests domestic currency use persists even under high inflation.
  - Transition unpredictability underscores the need for planning, transparency, and public education.

### Communication, legal tender, and trust
- Only local currency is legal tender and needed for making good on various obligations.
- To avoid an outright large-scale destabilizing run on the domestic currency in connection with the introduction of a dual local currency system, the central bank would have to communicate the system and its merits well and carefully.
- Successful communication would recreate confidence that monetary policy has new and unlimited room to address a downturn and should thereby reduce crisis sentiments present when introducing such a system.
- Transparency and the quality of communication of the system would be key for building trust.
- The central bank would have to be prepared in terms of foreign exchange reserve adequacy or macroprudential measures to prevent balance sheet vulnerabilities to large-scale capital flight episodes.

### C. Deeply negative rates and monetary policy transmission
- Purpose: introduce dual local currency system to move interest rates into deeply negative territory when nominal interest rates are near zero.
- Assessment: tentative yes that deeply negative policy rates can stimulate the economy; more research needed and discussion is speculative due to no historical precedence.
- Tradeoff: uncertainty of deeply negative rates must be weighed against the adverse implications of inability to provide monetary stimulus at the lower bound.
- Potential benefits:
  - Cutting interest rates into deeply negative territory could help shorten a downturn and the resulting low-growth period, getting the economy faster back on track.
- Transmission observations:
  - Interest rates on money and bond markets have fallen in line with monetary policy rates like in normal times when interest rates became negative.
  - No convincing reason why such rates would not keep declining with policy rates if lowered further.
  - Whether bank lending rates would follow is less clear; some studies question transmission to bank lending when rates become too low (Brunnermeier and Koby (2017) — "reversal rate"; Eggertson et al. (2017) — lower bound for deposit rates).
  - The cited studies assume a zero yield on cash and therefore a lower bound on deposit rates. With a negative yield on cash and if deposit rates breach the sticky line of zero, the authors see no technical impediments for banks to transmit interest rate changes to deposits and lending at a deeply negative interest rate level.
- Savings and investment behavior:
  - Real interest rates matter more than nominal rates.
  - Real interest rates have been negative on many occasions (e.g., in the 1970s and during post-global financial crisis years).
  - Little evidence that negative real rates generate a discrete behavioral shift toward savings, though more research is desirable.
  - Cannot exclude that deeply nominal interest rates might lead to increased saving due to money illusion; communication and financial education can reduce money illusion.
- Conclusion: No reasons identified to anticipate that monetary policy transmission to savings and investment would be hampered with deeply negative interest rates; main uncertainty is unknown effects of deeply nominal rates due to money illusion. Associated risks can be minimized with appropriate communication and education.

### D. Deeply negative rates and financial stability
- Five possible implications summarized:
  1. The system could strengthen financial stability by removing an incentive for large-scale deposit withdrawals, presuming the CRC is transmitted so agents are indifferent between cash at zero nominal return with depreciating prices and electronic money subject to a negative rate.
     - Authorities could use the CRC rate actively to steer incentives to run into cash.
     - Financial stability concerns could arise if an electronic legal tender is made accessible for all citizens; universal access could make generalized bank runs more severe if deposits can be withdrawn quickly and safely stored electronically with the central bank.
     - Problem is mitigated if central banks stand ready as lenders of last resort; bank funding models would have to change if faced with competition from a universal legal tender.
  2. If unit-of-account issues are properly addressed, stability implications related to changes in the value of financial contracts could be minimized.
  3. Negative interest rates and bank profitability:
     - Banks generally have not been willing to impose negative interest rates on retail deposits.
     - Bank funding costs have not decreased as much as policy rates, narrowing interest margins.
     - No evidence that bank profitability has been negatively affected by negative interest rates per se.
     - In a dual local currency system, deposit rates would be unlikely to remain sticky around zero and interest margins could be preserved.
     - Converting electronic currency into cash and vice versa at a crawling conversion rate could become a new source of income for banks.
  4. Business-model nominal rigidities and institutional money illusion:
     - Pension funds and other institutions might not adjust nominal commitments sufficiently, becoming financially fragile, or might intensify search-for-yield behavior.
     - Heider et al. (2017) find evidence that deposit-funded banks start to lend to riskier borrowers when interest rates become negative.
  5. Other practical issues:
     - Change in direction of interest payment flows and current definition of default; negative coupons on bonds are impractical as issuer would have to collect interest from bond holder.
     - Negative yields on bonds have been achieved by issuing bonds above par; slightly negative rates are unproblematic, but significantly negative rates could raise issues.
     - With negative rates, present values can become unbounded.
     - Tax treatment complications: taxes often apply to coupon payments but not to capital gains.
- Overall assessment: Whether a system allowing deeply negative rates would have adverse financial stability implications is unclear. There are clear negative consequences of long periods of below-average interest rates and growth. Implementation would require caution, legal and regulatory changes, close monitoring, and readiness to adapt.

### E. Implications for seigniorage revenues
- Key dependence: Effects on seigniorage depend on whether commercial banks or the central bank provide non-banks with electronic currency.
- General points:
  - Although the central bank would not incur losses as long as interest rates are negative, the situation could change once interest rates rise.
  - If the CRC were to remain in place with positive policy rates, the central bank would be required to remunerate reserve accounts at the policy rate.
  - Seigniorage arises from the difference between yields on central bank assets and its liabilities.
  - Currently, zero interest rate on cash (and in some countries also reserves) is primary source of seigniorage revenue.
  - Increased use of electronic means of payment at expense of cash can affect long-term profitability of the central bank; a decrease in cash in circulation and reduction of the central bank’s balance sheet could decrease seigniorage.
  - More research is needed to assess how much seigniorage could decrease and whether it could be severe enough to affect the central bank’s ability to pursue its price stability target.
- Balance-sheet considerations:
  - If the central bank supplies digital currency to non-banks, increased demand for electronic legal tender would lengthen the central bank’s balance sheet, forcing it to acquire more (interest-bearing) assets to counterbalance increased liabilities.
  - This could raise governance issues as more credit is intermediated through the central bank instead of the private sector; a larger share of liabilities would be remunerated at the policy rate.
  - While the yield spread becomes smaller when interest-bearing reserves replace cash, seigniorage revenues might increase or decrease depending on balance sheet expansion.
- Broader context:
  - Seigniorage revenue likely to change in future irrespective of a dual system, driven by financial innovation and increased electronic payments.

### V. Conclusions
- Cause of ZLB: The zero lower bound on nominal interest rates is due to availability of cash that yields a zero nominal return.
- Proposal: De-bundling cash from electronic currency and making cash depreciate relative to electronic currency (as proposed by Buiter (2007) and Kimball (2015)) could solve the ZLB problem.
- Benefits of a dual local currency system:
  - Central bank would be able to use conventional monetary policy tools without lower bound constraints to stabilize the economy.
  - In a world of low neutral real interest rates, it would help reduce the length of business cycle downturns and duration of low interest rate episodes.
  - It would do so without dispensing with cash.
  - Studies that question transmission of negative rates to bank lending assume banks cannot lower deposit rates, which would not be a constraint in a dual local currency system.
  - Technically feasible and would not require drastic changes to current mandates or operating frameworks of central banks.
  - Fully reversible; could be exited after normalization of economic conditions.
  - Preserves a role for cash and would reconfirm the central bank’s commitment to the inflation target rather than raise doubts about it.
  - Can be implemented as a crisis measure with some preparation beforehand.
- Drawbacks and challenges:
  - Enormous communicational challenge.
  - Requires more far-reaching legal and financial system changes than raising the inflation target or pursuing QE.
  - Key challenge: ensuring electronic currency becomes the relevant unit of account despite continued presence of cash — prerequisite to overcome the ZLB.
  - No historical precedent to guide legal and regulatory changes necessary to make people regard prices set in electronic currency as relevant to economic decisions.
- Relative comparison to alternatives:
  - Raising the inflation target and QE do not remove the lower bound but shift it downward by some percentage points (Ball et al. 2016).
  - Advantage of the dual local currency: completely frees monetary policy from a lower bound, allowing effective redressing and shortening of recessions.
  - Raising the inflation target ideally done in good times to build credibility; using it as a crisis measure works via expectations and requires strong credibility.
- Implementation advice:
  - Address possible risks to transmission and financial stability with clear and targeted central bank communication and financial education.
  - Further work needed to identify, prepare and implement necessary legal reforms for effective operation.
  - Compare pros and cons of a dual local currency system and alternatives in context of countries’ institutional, legal, cultural and economic situations.

*Source: IMF Working Paper wp18191 (selected sections from the provided PDF).*

### References .............................................................................................................

### wp18191 - References

### I. Introduction and context
- The global financial crisis brought policy rates to the so-called zero lower bound (ZLB) in many countries; "Some countries are still at this lower bound ten years after, and others are very close."
- Larry Summers warned central banks may not have sufficient policy space to counter the next recession, noting "countries should be able to cut rates by 500 basis points" to respond to important negative shocks.
- "Figure 1 shows that all but two OECD countries have monetary policy space that exceeds 500 basis points, and only three have policy space in excess of 250 basis points."

### The lower bound and the role of cash
- The lower bound on interest rates is due to the existence of cash, which "by design yields a nominal interest rate of zero."
- If a central bank attempts to move its policy rate significantly below zero:
  - commercial banks' interest margins will be compressed unless they charge negative interest on deposits;
  - depositors may switch from (negative) interest-bearing deposits to cash, potentially causing "a substantial outflow of deposits from the banking sector."
- Substitution from deposits and reserves into cash underlies the existence of the lower bound.
- Recent experience suggests "the lower bound is somewhat below zero," because storing and handling cash involves cost and inconvenience relative to deposit accounts.
- "No large-scale substitution toward cash has been observed in connection with negative interest rates as of yet," but substitution would occur if interest rates became sufficiently negative and would erode banks’ funding base.
- Large-scale substitution into cash would undermine intended stimulating effects of deeply negative policy rates because "the zero rate on cash, and not the negative rate on central bank reserves, would become the economically relevant interest rate."

### Proposals to increase monetary policy space
- Numerous proposals have been made to increase the ability of monetary policy to provide stimulus at the ZLB, including:
  - raising the inflation target,
  - adjusting exchange rate policy,
  - conducting large scale asset purchases,
  - phasing out cash to allow for substantially negative interest rates (Blanchard 2010, Williams 2017, Svensson 2003, Ball et al. 2016 and Rogoff 2014).
- Each proposal has advantages and drawbacks; "only the latter fully removes the lower bound constraint."

### Decoupling cash from electronic money: concept and purpose
- The paper discusses "the practical feasibility of decoupling cash from electronic money, as a way of fully removing the lower bound on monetary policy while preserving a role for cash" (Kimball 2015, Buiter 2007, Goodfriend 2016).
- Decoupling would effectively establish "a dual local currency system" allowing substantially negative interest rates without large-scale substitution into cash by engineering "a similarly negative yield on cash in terms of electronic currency."
- The paper covers how such a system "could be designed and operated" and highlights unresolved questions.

### Unanswered questions and areas for further research
- Remaining questions concern:
  - legal and institutional implications,
  - the transmission of monetary policy,
  - financial stability,
  - seigniorage revenues.
- The authors note "more research is needed."

### Overall assessment and policy stance
- While decoupling cash from electronic money "might sound impracticable," the paper concludes that with further conceptual development and research "the system is feasible and would fully restore monetary policy space with negative interest rates."
- The paper emphasizes that "Its pros and cons will differ across countries, and should be considered alongside the pros and cons of other proposals for increasing monetary policy space in a low-interest rate environment."

*Source: wp18191 - References*

### Section III, we describe how the dual local currency system that preserves a role for

### wp18191 - Section III, we describe how the dual local currency system that preserves a role for

### II. Why not simply phase out cash?
- Key uses of cash identified:
  - Retail payments.
  - Storage (hoarding of banknotes as a means of saving).
  - Tax evasion and illegal activities.
- Observations and country experience:
  - Some countries (notably Sweden) are moving quickly toward a cashless society; others remain strongly reliant on cash.
  - Only two countries – Sweden and Norway – saw an outright reduction in currency in circulation in percent of GDP in the past decade.
  - Countries with relatively high outstanding amounts of currency in circulation also had high growth rates in the past decade, indicating divergent developments across countries.
- Reasons that phasing out cash may be premature or undesirable:
  - Cash dominance in retail payments (e.g., cash still the dominant payment instrument at the point of sale in the euro area).
  - Disproportionate impact on demographic groups: low-income and older population groups tend to use electronic means of payment less.
  - Cash provides anonymity and is valued for privacy in some countries.
  - Cash is not electronic: it functions during electronic system breakdowns (valuable in areas prone to natural disasters).
  - Abolishing cash is hard to reverse; a dual local currency system would keep current payment infrastructures operational.

### III. Decoupling cash from electronic money — core concept and operational design
- Core idea:
  - Decouple cash from electronic money by splitting the domestic monetary base into two local currencies: cash (physical banknotes and coins) and reserves (electronic, central-bank reserves).
  - Reserves would pay nominal interest, possibly negative. The overnight rate on reserves is denoted i_R_t (the policy rate).
  - Central bank sets a spot cash reserve conversion (CRC) rate for cash withdrawn from or deposited in the central bank’s reserve accounts and supplies cash fully elastically on demand against reserves at this price.
- CRC operational mechanics:
  - Banks depositing cash to reserve accounts are credited at the prevailing CRC rate (not at par); withdrawals debit reserve accounts at the CRC rate.
  - The rate of change of the CRC determines the yield on cash in terms of reserves.
  - Central bank adjusts the CRC (preferably continuously, e.g. daily) to impose a deterrent negative yield on cash in terms of reserves when reserves carry a negative interest rate.
  - The cash yield in terms of reserves is i_C_t (annualized during time units d between CRC adjustments). The CRC is defined by an expression involving i_C_t and d (as presented in the source).
  - The CRC can be set such that the negative yield on cash equals the negative interest rate on reserves, or it can deviate (slightly less negative or more negative) to steer demand for cash.
- Operational considerations:
  - Continuous (preferably daily) CRC adjustments avoid discrete wealth redistributions and speculation.
  - Central bank could announce end-of-day CRC for the following business day, or announce a path until the next policy meeting.
  - The dual local currency system could remain in place even when interest rates return positive; trade-offs include reduced seigniorage if structural shift to non-cash payments occurs.

### Numerical example (preserved exactly as in the source)
- Scenario setup:
  - Suppose a central bank moves from a zero to a negative rate of −3% p.a. on reserve accounts at the central bank.
  - To prevent hoarding, the central bank announces a dual local currency system with an initial CRC0 = 100 (defined in units of cash per 100 units of reserves).
  - The central bank sets the yield on cash in terms of reserves equal to the interest on reserves (for simplicity).
  - It announces that tomorrow’s CRC will be ܥܴܥ1 = 100.0085.1
- Evolution:
  - After a year with −3% p.a. interest on reserves, the CRC rate would be 103, and 100 units of cash would be converted into roughly 97 units of reserves.
  - Figure 4 (in source) is based on monthly CRC adjustments for illustration.
- Exit dynamics (preserved values and timing):
  - In the example, the negative interest rate is abandoned at month 13.
  - The CRC is kept at 103 for as long as the interest on reserves remains zero.
  - In month 18, central bank tightens policy to 3% p.a.; the CRC starts reversing so that the yield on cash in terms of reserves becomes a positive 3% p.a.
  - If the interest rate remains at 3%, the CRC rate returns to par in month 30; at that point the system can be safely exited.
- Notes:
  - The square root expression used in the example refers to the daily equivalent gross compound interest of a yearly interest rate of −3%, with a year defined as 360 days.
  - The central bank cannot exit by a discrete appreciation of cash to par without redistributing wealth and encouraging speculative runs into cash; exit must await the CRC naturally return to par or follow an announced path to avoid disruption.

### Foreign exchange and arbitrage implications
- With dual domestic currencies, there would be two domestic-to-foreign exchange rates: one for domestic cash per foreign currency, and one for domestic electronic money (reserves) per foreign currency.
- The central bank deterministically fixes the domestic cash–reserve exchange (CRC); the market sets the two domestic-to-foreign exchange rates.
- Uncovered interest parity (UIP) relations among the three exchange rates would be maintained when cash depreciates at the rate consistent with the negative interest rate on reserves.
- No new unlimited arbitrage opportunities arise compared to a closed economy as long as the CRC is set according to the described principles; currency controls or market rationing are not required.

### B. Transmission beyond banks
- Transmission path highlights:
  - Whether and how commercial banks pass on the CRC to customers is a business decision, not mandated by the central bank.
  - Cash handling companies (that move cash between central bank and commercial banks) and their pricing choices play a central role in transmission.
  - Symmetric application of CRC by the central bank (applying to both withdrawals and redeposits) is crucial to prevent short-circuiting the cash cycle.
- Likely pass-through dynamics:
  - For short and mild episodes of negative policy rates (e.g., below a margin of a few percentage points and within a reasonably short period), CRC pass-through to retail customers might not occur immediately because of one-off adaptation costs for banks and existing ATM unit conversion factors.
  - If banks have already incurred one-off adaptation costs, pass-through could be immediate.
  - For longer or deeper negative-rate episodes, the conversion cost becomes steep enough that banks and firms would likely pass it on; institutional non-bank firms and non-financial firms are likely to see the CRC passed on earlier than households and small enterprises.
- Cash circulation implications:
  - Banks decide whether retail customers withdraw cash at par or at CRC; shops accept cash and bring it back to banks, which would likely credit firms’ accounts at the conversion rate they face (less than par).
- Pricing and unit-of-account uncertainty:
  - Crucial unanswered question: which currency (cash or reserves) becomes the main unit of account?
  - Firms may first incentivize customers toward electronic payments (e.g., bonuses or coupons for non-cash payments) before changing posted prices.
  - If the value of cash deviates substantially from reserves, firms may choose different currencies for price quotes, causing dual nominal price paths.
  - The choice of unit of account determines whether the ZLB on cash is removed in practice (electronic currency must be the unit of account for negative reserve rates to lower real interest rates).

### IV. Issues and unanswered questions
- Implementation requires legal and financial framework changes; specifics are country- and context-specific and beyond the paper’s scope.
- Main open issues addressed:
  - A. The Unit of Account and Legal Tender
    - Money functions: means of exchange, unit of account, store of value.
    - For a dual local currency system to remove the ZLB, the electronic currency must become the unit of account; prices, wage contracts and important nominal contracts should predominantly be written in electronic currency.
    - Legal tender implications:
      - Legal tender status historically supports the unit-of-account function.
      - In most countries, cash is legal tender; central bank reserves are sometimes included.
      - Bank deposits are not legal tender; they circulate by convention and trust.
    - Options and trade-offs discussed:
      - Revoking legal tender status of cash (advocated by Kimball 2013) would deprive non-bank citizens of access to legal tender unless electronic legal tender is made widely accessible.
      - Electronic legal tender could be provided to non-bank citizens via central bank deposit and payments facilities or via bank special deposits backed by central bank reserves; special deposits could be granted legal tender status.
      - A widely accessible electronic legal tender could fundamentally alter banking structure, deposit demand, seigniorage, and credit allocation—issues beyond this paper’s scope.
    - Contracts and legacy issues:
      - Essential that new contracts be written in electronic currency.
      - Legacy contracts that do not specify a means of payment pose redistribution risks: debtors could repay in depreciating cash, shifting wealth from creditors to debtors.
      - Recurrent payment contracts (mortgages, wages) are particularly problematic.
      - Transition requires legal amendments clarifying which currency contracts refer to and ensuring taxes and state contracts use electronic currency (Buiter 2007 recommendations).
  - B. Behavioral responses in the transition
    - Uncertainty: initial behavioral responses are unknown; public learning and financial literacy matter.
    - Risks and practical concerns:
      - Poor communication or misunderstanding could temporarily induce runs into cash (e.g., citizens might think negative-interest deposits mean they get more cash for deposits).
      - Temporary cash shortages could result; preparations should include clear communication, large cash stocks, and financial education.
      - Introduction of such a regime could signal crisis and erode trust, potentially accelerating shifts to alternative currencies (foreign currency, gold, cryptocurrency), though historical evidence suggests domestic currency use persists even under high inflation.
    - Transition unpredictability underscores the need for planning, transparency, and public education.

*Italic source attribution: Excerpts from "Section III" of wp18191 (IMF working paper), as provided in the supplied content.*

### introduction of a dual local currency system, it would not change the fact that only

### wp18191 - introduction of a dual local currency system, it would not change the fact that only

### Communication, legal tender, and trust
- Only local currency is legal tender and needed for making good on various obligations.
- To avoid an outright large-scale destabilizing run on the domestic currency in connection with the introduction of a dual local currency system, the central bank would have to communicate the system and its merits well and carefully.
- Successful communication would recreate confidence that monetary policy has new and unlimited room to address a downturn and should thereby reduce crisis sentiments present when introducing such a system.
- Transparency and the quality of communication of the system would be key for building trust.
- The central bank would have to be prepared in terms of foreign exchange reserve adequacy or macroprudential measures to prevent balance sheet vulnerabilities to large-scale capital flight episodes (see footnote 23).

### C. Deeply negative rates and monetary policy transmission
- Purpose: The whole reason for introducing a dual local currency system is to be able to move interest rates into deeply negative territory in response to strong downturns when nominal interest rates are near zero.
- Assessment: The authors offer a tentative yes that deeply negative policy rates can stimulate the economy, but call for more research and note the discussion is speculative due to no historical precedence.
- Tradeoff noted: Uncertainty of deeply negative rates must be weighed against the certain adverse implications of inability to provide monetary stimulus at the lower bound.
- Potential benefits:
  - Being able to cut interest rates into deeply negative territory could help shorten a downturn and the resulting low-growth period, getting the economy faster back on track and thus back into positive interest rate territory.
- Transmission observations:
  - Interest rates on money and bond markets have fallen in line with monetary policy rates like in normal times when interest rates became negative.
  - There is no convincing reason why such rates would not keep declining with policy rates if lowered further.
  - Whether bank lending rates would follow is less clear; some studies question transmission to bank lending when rates become too low (Brunnermeier and Koby (2017) — "reversal rate"; Eggertson et al. (2017) — lower bound for deposit rates).
  - The cited studies assume a zero yield on cash and therefore a lower bound on deposit rates (footnote 24). With a negative yield on cash and if deposit rates breach the sticky line of zero, the authors see no technical impediments for banks to transmit interest rate changes to deposits and lending at a deeply negative interest rate level.
- Savings and investment behavior:
  - What should matter is the real interest rate, not the nominal rate.
  - Real interest rates have been negative on many occasions (e.g., in the 1970s and during post-global financial crisis years).
  - If changes in neutral real interest rates are appropriately accounted for, such episodes seem associated with improvements in macroeconomic conditions (Krogstrup 2017).
  - There is little evidence that negative real rates generate a discrete behavioral shift toward savings (see also Ball et al. 2016), though more research is desirable.
  - Cannot exclude that deeply nominal interest rates might lead to increased saving due to money illusion; more research (including experimental methods) is needed.
  - Clear and targeted central bank communication and financial education could reduce money illusion; a shift to a dual local currency regime could itself reduce money illusion by confronting agents with more than one unit of account.
- Conclusion: No reasons identified to anticipate that monetary policy transmission to savings and investment would be hampered with deeply negative interest rates; main uncertainty is unknown effects of deeply nominal rates due to money illusion. Associated risks can be minimized with appropriate communication and education and are likely transitional.

### D. Deeply negative rates and financial stability
- Framing: Considerations speculative but must be weighed against adverse implications of not being able to provide monetary stimulus at the lower bound.
- Five possible implications discussed; summarized findings:
  1. Dual local currency system could strengthen financial stability by removing an incentive for large-scale deposit withdrawals, presuming the CRC is transmitted to wholesale and retail cash prices so agents are indifferent between cash at zero nominal return with depreciating prices and electronic money subject to a negative rate.
     - Authorities could use the CRC rate actively to steer incentives to run into cash.
     - Financial stability concerns could arise if an electronic legal tender is made accessible for all citizens; universal access could make generalized bank runs more severe if deposits can be withdrawn quickly and safely stored electronically with the central bank.
     - Problem is mitigated if central banks stand ready as lenders of last resort; bank funding models would have to change if faced with competition from a universal legal tender.
     - Footnote 25 notes similar concerns in context of the Federal Reserve’s reverse repurchase (RRP) program.
  2. If unit-of-account issues are properly addressed in design and transition, financial stability implications related to changes in the value of financial contracts could be minimized.
  3. Negative interest rates and bank profitability:
     - Banks generally have not been willing to impose negative interest rates on retail deposits (Jackson 2015, Jobst and Lin 2016, Bech and Malkhozov 2016).
     - Bank funding costs have not decreased as much as policy rates, narrowing interest margins.
     - In general, there is no evidence that bank profitability has been negatively affected by negative interest rates per se (Ball et al. 2016).
     - Banks have increased fee-based revenue or lowered lending rates less than usual to maintain profitability.
     - In a dual local currency system, deposit rates would be unlikely to remain sticky around zero and interest margins could be preserved.
     - Converting electronic currency into cash and vice versa at a crawling conversion rate could become a new source of income for banks.
  4. Business-model nominal rigidities and institutional money illusion:
     - Pension funds and other institutions might not adjust nominal commitments sufficiently, becoming financially fragile, or might intensify search-for-yield behavior.
     - This risk is not specific to negative interest rates but relevant for long periods of below-average rates.
     - Heider et al. (2017) find evidence that deposit-funded banks start to lend to riskier borrowers when interest rates become negative (footnote 29).
  5. Other practical issues (McAndrews 2015):
     - Implied change in direction of interest payment flows and current definition of default; negative coupons on bonds are impractical as issuer would have to collect interest from bond holder.
     - Negative yields on bonds have been achieved by issuing bonds above par; slightly negative rates are unproblematic, but significantly negative rates could raise issues.
     - With negative rates, present values can become unbounded.
     - Tax treatment complications: taxes often apply to coupon payments but not to capital gains (footnote 32).
- Overall assessment: Whether a system allowing deeply negative rates would have adverse financial stability implications is unclear. There are clear negative consequences of long periods of below-average interest rates and growth. Implementing a dual local currency system would have to be done cautiously with appropriate legal and regulatory framework, close monitoring, and readiness to adapt.

### E. Implications for seigniorage revenues
- Key dependence: Effects on seigniorage depend on whether commercial banks or the central bank provide non-banks with electronic currency.
- General points:
  - Although the central bank would not incur losses as long as interest rates are negative, the situation could change once interest rates rise.
  - If the CRC were to remain in place with positive policy rates, the central bank would be required to remunerate reserve accounts at the policy rate (footnote 33).
  - Seigniorage arises from the difference between yields on central bank assets and its liabilities.
  - Currently, zero interest rate on cash (and in some countries also reserves) is primary source of seigniorage revenue.
  - Increased use of electronic means of payment at expense of cash can affect long-term profitability of the central bank; a decrease in cash in circulation and reduction of the central bank’s balance sheet could decrease seigniorage.
  - More research is needed to assess how much seigniorage could decrease and whether it could be severe enough to affect the central bank’s ability to pursue its price stability target.
- Balance-sheet considerations:
  - If the central bank supplies digital currency to non-banks, increased demand for electronic legal tender would lengthen the central bank’s balance sheet, forcing it to acquire more (interest-bearing) assets to counterbalance increased liabilities.
  - This could raise governance issues as more credit is intermediated through the central bank instead of the private sector; a larger share of liabilities would be remunerated at the policy rate.
  - While the yield spread becomes smaller when interest-bearing reserves replace cash, seigniorage revenues might increase or decrease depending on balance sheet expansion.
- Broader context:
  - Seigniorage revenue likely to change in future irrespective of a dual system, driven by financial innovation and increased electronic payments.
  - Debate: Friedman (1999) worried evaporating demand for base money would make it harder for central bank to control financing conditions; Woodford (2000) argued central banks could continue to control short-term rates even if demand for base money were eliminated.

### V. Conclusions
- Cause of ZLB: The zero lower bound on nominal interest rates is due to availability of cash that yields a zero nominal return.
- Proposal: De-bundling cash from electronic currency and making cash depreciate relative to electronic currency (as proposed by Buiter (2007) and Kimball (2015)) could solve the ZLB problem.
- Benefits of a dual local currency system:
  - Central bank would be able to use conventional monetary policy tools without lower bound constraints to stabilize the economy.
  - In a world of low neutral real interest rates, it would help reduce the length of business cycle downturns and duration of low interest rate episodes.
  - It would do so without dispensing with cash.
  - Studies that question transmission of negative rates to bank lending assume banks cannot lower deposit rates, which would not be a constraint in a dual local currency system.
  - Technically feasible and would not require drastic changes to current mandates or operating frameworks of central banks.
  - Fully reversible; could be exited after normalization of economic conditions.
  - Preserves a role for cash and would reconfirm the central bank’s commitment to the inflation target rather than raise doubts about it.
  - Can be implemented as a crisis measure with some preparation beforehand.
- Drawbacks and challenges:
  - Enormous communicational challenge.
  - Requires more far-reaching legal and financial system changes than raising the inflation target or pursuing QE.
  - Key challenge: ensuring electronic currency becomes the relevant unit of account despite continued presence of cash — prerequisite to overcome the ZLB.
  - No historical precedent to guide legal and regulatory changes necessary to make people regard prices set in electronic currency as relevant to economic decisions.
- Relative comparison to alternatives:
  - Should be considered alongside alternatives (higher inflation target, QE).
  - Raising the inflation target and QE do not remove the lower bound but shift it downward by some percentage points (Ball et al. 2016).
  - Advantage of dual local currency: completely frees monetary policy from a lower bound, allowing effective redressing and shortening of recessions.
  - Raising the inflation target ideally done in good times to build credibility; using it as a crisis measure works via expectations and requires strong credibility (footnote 34).
- Implementation advice:
  - Any possible risks to transmission and financial stability should be addressed with clear and targeted central bank communication and financial education.
  - Further work needed to identify, prepare and implement necessary legal reforms for effective operation.
  - Pros and cons of a dual local currency system and alternatives should be compared in context of countries’ institutional, legal, cultural and economic situations.

*Source: IMF Working Paper wp18191 (selected sections from the provided PDF).*

### REFERENCES

### REFERENCES

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### Digital Currency, Virtual Money, and Reserve Regimes
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### Payment Systems, Cash Usage, and Electronic Payments
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### Monetary Policy Frameworks, Real Interest Rates, and Macro Policy
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### Banking, Bank Business Models, and Financial Stability
- Lucas, Andre, Julia Schaumburg and Bernd Schwaab (2017), “Bank business models at zero interest rates” ECB Working Paper no. 2084.  
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### Historical, Theoretical, and Conceptual Foundations of Money
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- Buiter, Willem. H. and Nikolaos Panigirtzoglou (2003), “Overcoming the Zero Bound on Nominal Interest Rates with Negative Interest on Currency: Gesell’s Solution,” The Economic Journal 113: 723–746.  

*Source: wp18191 - REFERENCES (PDF chapter/section).*

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_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp18191.pdf_