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Novembre 2002
Claudio Sardoni – Alessandro Verde
THE ‘IT REVOLUTION’ AND THE MONETARY SYSTEM: ELECTRONIC

MONEY AND ITS EFFECTS
42
nuova serie
DIPARTIMENTO DI SCIENZE ECONOMICHE – Via Andrea Cesalpino, 12/14

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The ‘IT revolution’ and the monetary system:
Electronic money and its effects
C. Sardoni–A. Verde♦
Abstract
Within the context of the general debate on the economic impact of advances in information
technology, in the last few years there has been a growing attention for the effects that such innovations
have on the working of the monetary system. In this paper, we deal with this topic by focusing our
attention on a specific aspect, the role and the effects of electronic money (e-money) on the monetary
system.
In the debate on the effects of the IT revolution on the monetary system, two contrasting positions have
emerged. On the one hand, some believe that recent technological developments can reduce
significantly the use of conventional money for transactions and, possibly, for ultimate settlements. As
a consequence of such evolution, the importance of central banks would be seriously reduced. On the
other hand, others have responded by holding that IT advances do not imply any radical changes of the
existing monetary organization in advanced economies. In dealing with the IT revolution in the
monetary sector, many refer to e-money as a typical exemplification of what this revolution can bring
about.
In this paper, having adopted the definition of e-money given by the European Central Bank, we
compare this new means of payment to other more traditional means (section 2) and study some of its
effects on the monetary system by using a simple model (section 3). We consider both cases in which
e-money is issued by the banking sector and cases in which it is issued by firms that do not belong to
the banking sector.
Opinions on the potential effects of e-money differ, but there is an almost universal consensus on the
fact that, in the immediate or near future, e-money will not spread significantly in advanced monetary
economies. Section 4 looks at some of the factors that can prevent a rapid and wide diffusion of e-
money.
The following section 5 looks at some of the more recent contributions to the debate on the impact of
the IT on the monetary system, by concentrating on e-money and its possible effects on the ability of
central banks to implement effective monetary policies. In the concluding section 6, we argue that the
radical changes of the monetary system envisaged by some authors are quite unlikely if e-money
maintains its current characteristics, which are well represented by the ECB definition. Accepting this
definition of e-money implies, in our opinion, that conventional money continues to play a relevant role
in the economy.
A radical change of the existing monetary system, with all its implications in terms of policy, require
innovations that can take place only if e-money becomes significantly different from what it currently
is. We outline some basic characteristics that e-money should have to support the idea that the IT
revolution is a serious threat for central banks and monetary policy. In particular, we argue that in order
to arrive at a world in which central banks have, mostly or entirely, lost their power, it is necessary that
the economy adopts a means of payment that does not imply the necessary existence of conventional
money.
♦
University of Rome “La Sapienza”. This paper partly (especially sections 2 and 3) draws on
Verde’s graduate dissertation ‘Lo sviluppo di nuovi mezzi di pagamento: la moneta elettronica’
(University of Rome “La Sapienza”, academic year 1998-99). We would like to thank J. Bibow and
M. Sarcinelli for their helpful comments and suggestions, but the responsibility for any possible
error remains exclusively ours. A research grant to C. Sardoni from the Faculty of Statistics is
gratefully acknowledged.
The ‘IT revolution’ and the monetary system:
C. Sardoni–A. Verde
1. Introduction
In the last few years, there has been a growing debate on the economic effects of the
so-called information technology (IT) revolution; in particular much attention has
been paid to the effects that such revolution has, or can have in the future, on the
working of monetary and financial systems. In this paper, we deal with this topic by
focusing our attention on a specific aspect, the role and the effects of electronic
money (e-money) on the monetary system.
In the recent debate on the effects of the IT revolution on the monetary system, two
contrasting positions have emerged. On the one hand, some believe that recent
technological developments can reduce significantly the use of conventional money
for transactions and, possibly, for ultimate settlements. As a consequence of such
evolution, the importance of central banks (and traditional commercial banks as well)
would be seriously reduced. On the other hand, others have responded by holding that
IT advances do not imply any radical changes of the existing monetary organization
in advanced economies. In dealing with the IT revolution in the monetary sector,
many refer to e-money as a typical exemplification of what this revolution can bring
about.
One of the problems of the discussion of the effects of e-money on the monetary
system is that it is not always clear what is precisely meant by such term.1 In our
opinion, a satisfactory discussion of the effects of e-money on the monetary system
requires a more careful definition of what is meant by e-money itself; therefore
section 2 of the paper is devoted to provide a clear-cut definition of e-money and an
outline of the main differences between it and other electronic means of payment as
well as conventional money. We adopt the European Central Bank definition of e-
money, which provides a good representation of the basic characteristics of most
1
Sometimes the notion of e-money is interpreted in very general terms, as a device that makes it
possible to carry out transactions electronically.
types of e-money currently available. In section 3, we turn to a more detailed analysis

of the effects of e-money on the monetary system by using a simple model. We
consider both cases in which e-money is issued by the banking sector and cases in
which it is issued by firms that do not belong to the banking sector.
Although opinions on the potential effects of the IT on the monetary system differ,
there is an almost universal consensus on the fact that the present situation of
advanced monetary economies will not change radically in the immediate or near
future. The demand for e-money is not expected to grow largely and rapidly in the
short or medium run. Section 4 looks at some of the factors that can prevent a rapid
and wide diffusion of e-money in advanced economies, even though it may have
characteristics that make it a more efficient means of payment than those currently
used.
The following section 5 looks at some of the more recent contributions to the debate
on IT and its impact on the monetary system. We concentrate on e-money and its
possible effects on the ability of central banks to implement effective monetary
policies. Finally, section 6 presents some concluding considerations. In this section,
we argue that the radical changes of the monetary system envisaged by some authors
are quite unlikely if e-money maintains its current characteristics, which are well
represented by the ECB definition. Accepting this definition of e-money implies, in
our opinion, that conventional money continues to play a relevant role in the
economy.
A radical change of the existing monetary system, with all its implications in terms of
policy, require innovations that can take place only if e-money becomes significantly
different from what it currently is. We outline some basic characteristics that e-money
should have to support the idea that the IT revolution is a serious threat for central
banks and monetary policy. In particular, we argue that in order to arrive at a world in
which central banks have, mostly or entirely, lost their power, it is necessary that the
economy adopts a means of payment that does not imply the necessary existence of
conventional money.
2. Money and e-money

Monetary transactions can be divided into two broad categories: those that require the
use of cash and transactions that do not. Non-cash transactions, in turn, are of two
4
Discussion Papers - Dipartimento di Scienze Economiche
types: paper-based and electronic. The latter imply, to a different extent and at
different phases of the process of exchange, the use of some electronic device. If
monetary transactions that take place in advanced economies are measured in value
rather than in number, already now the bulk of them are made in some electronic form
(see, e.g. Solomon 1997, p. 39).
Fig. 1 below illustrates the most common types of electronic transactions as opposed
to paper-based transactions.
Figure 1
Payments
Cash Non-cash
Paper-based Electronic
Checks Electronic fund transfers (EFT)
Paper transfers Cards
Credit cards
Debt cards
The fact that electronic transactions do not imply the use of cash and are not paper-
based does not mean that they do not require the existence of conventional money. All
the different types of electronic means of payment indicated in the figure above
require conventional money for ultimate settlements.
Also e-money is an electronic means of payment. There currently exist two main
types of e-money:
1. e-money based on cards (multifunction pre-paid cards bought by buyers);
2. e-money based on some type of software that allows buyers and sellers to
transfer funds through an electronic network.
5
Both types of e-money also require the existence of conventional money. In fact, in
both cases, users buy e-money from issuers by paying in advance with conventional
money a certain amount that then can be spent electronically. The main difference
between these two types of e-money is technical. The first type of e-money can be
regarded as more similar to other means of payment based on the use of a card, which
stores a certain amount of information.2 The second type of e-money resembles, in
some respects, electronic fund transfers (EFT). Both types of e-money can be issued
by banks as well as by firms outside the banking sector.
The definition of e-money recently given by the European Central Bank, which we
adopt here, is a good representation of the two types of electronic money just
described. For the ECB,
electronic money is broadly 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, p. 7).
It is clear that e-money defined in these terms cannot imply the disappearance of
conventional money. The public can obtain e-money only by purchasing it with
conventional money. Economic agents can acquire e-money only if they give its
issuer an equivalent counter-value in money. In other words, conventional money
remains necessary as the ultimate instrument to settle transactions.
More generally, e-money as defined above does not perform all the functions of
conventional money. The canonical functions of money (monetary base plus bank
money) are: it is a medium of exchange and payment; it is a store of value; it is the
asset in which debts are denominated; it is a unit of account. E-money currently
performs only the function of medium of exchange, but, in principle, it could also
become unit of account and standard of deferred payments. What e-money cannot do
is to perform the function of store of value in the same way as conventional money
does. Money is a store of value in the sense that economic agents may decide to keep
part or all of their wealth in a perfectly liquid asset that is called money. E-money is
defined as a store of value in the sense that economic agents may decide to keep part
2
Credit cards and ATM cards come to mind, even though they are conceptually different from e-
money based on a card. The issue of credit cards is analogous to the provision of a line of credit to
the cardholder, while ATM cards are a device used by banks to deliver cash and provide some other
information and services to their customers. For more details on these aspects, see, e.g., Solomon
1997, pp. 49-62.
6
of their liquid wealth in an electronic form.3 In this sense, the very term ‘electronic
money’ is a misnomer, as it can convey the wrong idea that it can be a perfect
substitute for conventional money.4
3. A simple model of the effects of e-money

In this section, we look at the effects of the introduction and diffusion of e-money
within a simplified analytical context. We are not concerned with the analysis of
changes in the total demand for liquidity, but we concentrate on the analysis of the
effects of changes in the composition of a given total demand for liquidity.5 In
particular, we look at the effects of such changes on the ratio of base money to total
money.
The basic model without e-money

Let us start by considering an economy with no e-money, where conventional money
is defined in a narrow sense, i.e. it is the aggregate M1 (currency plus demand
deposits).
Let M1 be the public’s total demand for money, with
C = cM 1 ( 0 ≤ c ≤ 1) (1)
that denotes the demand for currency and
D = dM 1 ( 0 ≤ d ≤ 1) (2)
that denotes the demand for deposits with commercial banks. Of course, it is c + d =
1.
If θD is the commercial banks’ reserve ratio, their demand for reserves is6
R = θ D dM 1 = θ D (1 − c ) M 1 (3)
3
In fact the European Central bank defines e-money as an ‘electronic store of monetary (emphasis
added) value’.
4
Solomon has expressed this point clearly: ‘much of what is called e-money really ought to bear
another name. A number of e-innovations create ingenious new ways to move around the money we
already keep in banks, but those ways don’t create a new value form’ (Solomon 1997, p. 64).
5
We are not concerned with money supply either. It can be assumed that the supply endogenously
adjusts to the total demand for money.
6
Total reserves that banks hold with the central bank can be partly required and partly free; for now,
however, we do not make any distinction between the two types of reserves.
7
By denoting base money with H, from (1) to (3) we have
H =  c + θ D (1 − c )  M 1 (4)
Therefore,
H
= B = c + θ D (1 − c ) (5)
M1
B is increasing in c and θD: the larger is the proportion of currency that the public
wishes to hold, the higher is the ratio of base money to total money; the higher is the
banks’ reserve ratio, the higher is the ratio of base money to total money.
E-money issued by commercial banks (‘bank’ e-money)

E-money issued by commercial banks can be regarded as a special type of demand
deposit. The public buys a certain amount of e-money from banks by paying for it
either in cash or by drawing checks on its conventional deposits. Banks treat the
revenue from selling e-money as deposits, on which they apply a certain reserve ratio
θEM.
Having defined e-money as a special type of demand deposit, it is natural to consider

it as part of the aggregate M1.
The public’s demand for e-money is
EM = mM 1 ( 0 < m ≤ 1) (6)
The demand for currency and conventional deposits respectively becomes
C = c1M 1 (7)
and
D = d1M 1 (8)
(with c1 + d1 + m = 1).
The banks’ demand for reserves now is
R = θ D D + θ EM EM (9)
and, therefore, the ratio of H to M1 becomes
8
H
= BEM = c1 + d1θ D + mθ EM (10)
M1
The ratio BEM can be equal to, larger, or smaller than the ratio B in (5) depending on
the values that c1, d1, θD and θEM take.
If there is a positive demand for e-money (m > 0), the proportion of the (given) total
demand for money held in currency and deposits must necessarily decrease, c1 + d1 <
c + d. But the decrease in the proportion of conventional money demanded can derive
from a reduction in the demand for currency, in the demand for deposits, or in both.
Here, we can usefully concentrate on two basic cases: situations in which a positive
demand for e-money implies a reduction in the demand for deposits whereas the
demand for currency remains constant; situations in which a positive demand for e-
money implies a reduction in the demand for currency while the demand for deposits
remains unchanged. The other possible cases can be easily inferred from them.
Case 1. c1 = c and d1 < d (e-money is bought with deposits)
In this case, it is d1 = (1 − c − m ) and BEM can be written as
BEM = c + (1 − c − m ) θ D + mθ EM (11)
BEM in (11) is equal to, larger or smaller than B in (5) depending on the sign of the
difference θ D − θ EM . More precisely,
1. θ D = θ EM ⇒ BEM = B
2. θ D > θ EM ⇒ BEM < B
3. θ D < θ EM ⇒ BEM > B
1. When banks apply the same reserve ratio to deposits and e-money, a positive
demand for e-money does not imply any change in the ratio of H to M1. The
public obtains all the e-money that wishes to hold by correspondingly reducing its
demand for conventional deposits, but this has no effect on H/M1 because the two
types of deposits have the same reserve ratio.
2. If the public buys e-money by reducing its demand for deposits with a higher
reserve ratio than e-money, the effect on the amount of money created by banks
9
(demand deposits plus e-money) is necessarily positive and the ratio of H to M1 is

lower.
3. Finally, if the public buys e-money by reducing its demand for deposits with a
lower reserve ratio than e-money, the effect on the amount of money created by
banks is necessarily negative and the ratio of H to M1 increases.
In other words, the ratio of base money to M1 is decreasing in m when θEM < θD, it is
increasing in m when θEM > θD and it is independent of m when θEM = θD. For any 0<
θD ≤ 1, BEM is minimum for θEM = 0.
Case 2. c1 < c and d1 = d (e-money is bought with currency)
In this case, it is c1 = (1 − d − m ) and BEM can be written as
BEM = 1 − d (1 − θ D ) − m (1 − θ EM ) (12)
which is smaller than B in (5) for any value of θEM < 17. BEM is increasing in θEM and
decreasing in m for any θEM < 1. If θEM = 1, BEM = B.
This result is obvious: when a positive demand for e-money is associated with a lower
demand for currency, the amount of money created by banks is larger and, therefore,
the ratio of base money to M1 decreases. An increase in the demand for e-money
associated to a decrease in the demand for currency produces effects that are
analogous to those produced by an increase in the public’s propensity to hold deposits
rather than currency in a world with only conventional money. Only if the reserve
ratio against e-money were equal to 1, a positive demand for e-money would fail to
imply any change in the ratio of base money to total money with respect to an
economy without e-money. In fact, in this case, demanding e-money is analytically
the same as demanding currency.
The general conclusion that can be drawn from the analysis above is that a positive
demand for e-money implies a smaller ratio of base money to M1 whenever the public
wishes to buy e-money from the banking system by paying in cash, i.e. by reducing
the amount of currency held. If there is a positive demand for e-money but the public
7 1
B can be written as .
1 − d (1 − θ D )
10
wishes to hold the same amount of currency as before, there is a decrease in the ratio
of H to M1 only if the banks’ reserves decrease, which can happen only if the e-money
reserve ratio is smaller than the deposit reserve ratio.
E-money issued by the central bank8

Let us now suppose that the central bank itself issues e-money and, therefore, e-
money is base money. We can envisage situations in which the central bank issues
only e-money or situations in which it issues both e-money and conventional
currency. In both cases, the relevant problem is whether the issuing of e-money
implies or not a reduction in the public’s demand for bank deposits.
If the central bank completely substitutes e-money for currency,9 we have
H = EM + R
EM = mM 1 (13)
D = (1 − m ) M 1
Therefore,
H
= BCB = m + (1 − m ) θ D (14)
M1
Obviously, if m = c in (5), we have that BCB = B. The introduction of e-money is a

mere technological change, a switch from the use of paper to an electronic device to
make exchanges. If, instead, once e-money created by the central bank is in
circulation, the public wishes to hold a larger proportion of it and, consequently, a
smaller proportion of deposits (m > c), the ratio of base money to total money is
larger. BCB clearly is increasing in m.
If it is hypothesized that the central bank issues both e-money and conventional
money, we have
H = EM ′ + C ′ + R
with
8
See Solomon 1997, pp. 78-83, for a discussion of some examples of e-money issued by central
banks.
9
For example, all the circulating conventional monetary base is bought by the central bank at a ratio
of 1:1.
11
EM ′ = m′M 1
C ′ = c′M 1
D′ = (1 − c′ − m′ ) M 1
Therefore,
H
′ = ( c′ + m′ ) + θ D (1 − c′ − m′ )
= BCB (15)
M1
If c′ + m′ = m, there is no change in the ratio H/M1 with respect to the previous case;
but if c′ + m′ > m the ratio is larger. Thus, the introduction of e-money issued by the
central bank can affect the ratio of base money to total money only if it implies a
change in the public’s propensity to hold e-money (or currency plus e-money) as
opposed to bank demand deposits.
E-money issued by non-banking firms (‘industrial e-money)

The ECB definition of e-money is comprehensive of electronic means of payment
issued by firms (or possibly other sorts of institutions) that do not belong to the
banking sector.10 From a technical viewpoint, e-money issued by industrial firms is
not different from e-money issued by banks: the public buys either cards or software
by paying in conventional money. However, the economic implications of ‘industrial’
e-money are not the same as for ‘bank’ e-money.
The basic difference between ‘industrial’ e-money and ‘bank’ e-money is that the
former cannot be regarded as a special type of deposit. When e-money is issued by
firms outside the banking sector, the public buys e-money by paying for it either in
cash or by drawing checks on deposits with banks. What the issuing firm receives as a
payment for its e-money is conceptually the same as what any firm receives in
payment for its goods or services.11 For the issuing firm, the public’s payment for its
e-money is part of its cash flow, which it can be used in whatever way the firm
wishes. However, by definition, the issuing firm cannot use the revenue from the sale
10
There already are several cases of e-money issued by industrial firms (for example, telecom
companies), even though such instruments normally are not universally accepted and are used to
purchase a limited number of goods or services.
11
More precisely, in the case of e-money, we have firms that benefit from a payment in advance for
the goods/services that they or other firms deliver or will deliver.
12
of e-money for lending: if the firm could lend what it receives for the issued e-money,
it would be a bank.
Therefore, e-money issued by non-banking firms cannot be regarded as a component

of M1, as it was the case for ‘bank’ e-money. In this case, if the hypothesis of a given
and constant total demand for liquidity is retained, a positive demand for ‘industrial’
e-money implies a reduction in the demand for M1 (currency plus demand deposits
with commercial banks).
Let us denote total demand for money by Mi, which is equal to the sum of ‘industrial’
e-money demanded by the public plus the demand for currency and the demand for
bank deposits,12
M i = EM + cM 1i + dM 1i (16)
where EM is the demand for e-money, cM1i is the demand for currency and dM1i is the
demand for bank deposits.13
The banks’ demand for reserves now is
Ri = θ D (1 − c ) M 1i (17)
Therefore the ratio of base money to total money (H/Mi) is necessarily decreasing in
EM. A positive demand for ‘industrial’ e-money implies a reduction in the ratio H/Mi.
If c and d are given and constant, the ratio H/M1i remains constant, but a positive
demand for ‘industrial’ e-money can also imply changes in the ratio of base money to
M1i. This ratio, in fact, depends on how the public finances its purchases of e-money.
If e-money from firms is bought with currency (i.e. the public substitutes ‘industrial’
e-money for currency), the ratio H/M1i will shift ‘in favor’ of commercial banks, i.e. it
decreases. If the public holds the same amount of cash and buys e-money by reducing
its deposits with banks, the ratio will increase.
More complex cases can be envisaged (for example, an economy with both
‘industrial’ and ‘bank’ e-money), but the basic result depicted above would not
change significantly: given the public’s total demand for liquidity, a positive demand
for e-money issued by non-banking firms determine a reduction in the demand for
12
For simplicity, we assume that there is no ‘bank’ e-money.
13
It is M1i = M1 in the previous sections, with M1i = M1 – EM.
13
conventional money, i.e. money issued by the banking sector as a whole (the central
bank and commercial banks).
The diffusion of e-money issued by firms outside the banking sector can be regarded
as analogous to well-known cases in which the demand for liquidity shifts from assets
defined as belonging to the aggregate M1 to assets classified under broader monetary
aggregates (M2, etc.). The major implication of a positive demand for ‘industrial’ e-
money is that the issuing firms would not have deposits (reserves) at the central bank,
so that an increase in the demand for their liabilities immediately implies a reduction
in the demand for base money. Moreover, like for the switching from M1 to broader
monetary aggregates, also for ‘industrial’ e-money problems of control and regulation
arise. Commercial banks traditionally are subject to the power of control of the central
bank and to other regulations, whereas non-banking firms are free from such controls.
***
The results above provide the basis for some more general considerations concerning
the effects of e-money. E-money issued by commercial banks is a sort of demand
deposit and, as such, it can be regarded as a component of money narrowly defined
(M1). When the public buys e-money, it makes an operation that is essentially the
same as opening a current account with a bank. Banks, on the other hand, treat their
liabilities created in this way as demand deposits, to which they apply a certain
reserve ratio. In this case, the impact of e-money on the aggregate M1 is conceptually
the same as the impact of conventional deposits. In particular, the ratio H/M1
decreases whenever the public substitutes e-money for currency, provided that the e-
money reserve ratio is less than 1. On the other hand, if the public substitutes e-money
for conventional deposits, this produces a decrease in the ratio H/M1 only if banks
apply a lower reserve ratio to e-money than to conventional deposits.
As for the case in which e-money is created outside the banking sector, while the
instrument issued has the same basic technical characteristics, the effects on monetary
aggregates are different. In this case a positive and growing demand for e-money
implies a decrease in M1 and a decrease in the ratio of base money to total money.
Even though the analysis of e-money issued by non-banking firms has been carried
out at a very simplified level, the results obtained are sufficient to indicate that it is
14
essentially this type of e-money than can represent a potential threat for the existing
monetary system and for central banks.
E-money issued by commercial banks implies a reduction in the demand for currency
and bank demand deposits, but it remains not too different from conventional money.
‘Industrial’ e-money, instead, cannot be treated as a special type of bank deposit. A
diffusion of ‘industrial’ money implies that, at least partly, the issuing of money takes
place outside the banking sector of the economy. It is this factor that can have a
significant impact on central banks and their ability to implement monetary policy.
4. The future of e-money

Although, as we shall see in the next section, opinions on the potential effects of the
IT revolution and e-money on the working of a monetary economy and central
banking differ, there is an almost universal consensus on the fact that the present
situation of advanced monetary economies is not going to change in the immediate or
near future. E-money, if it is ever going to be widely adopted, will take quite a long
time to become a largely used means of payment.
Such a conclusion, however, is not immediately obvious. In fact, e-money has a

number of characteristics that could rather lead to the opposite conclusion, i.e. that it
will be adopted quite rapidly in advanced economies. We first look at those factors
that could favor a fast process of adoption of e-money throughout the economy; we
then shall consider some of the factors that can act in the opposite direction, that is to
say factors that can hinder, if not block altogether, the process of diffusion of e-
money.
Let us start by considering, though in a very simplified analytical context, the public’s
decisions concerning the way in which its demand for money is distributed among
different instruments. For simplicity, we consider only currency, demand deposits and
e-money.14 The determination of how agents allocate their total demand for money
can be set in terms of a maximization problem. The use of each media of exchange
implies some costs and benefits; agents choose that combination of currency, deposits
and e-money that maximizes (minimizes) such benefits (costs). Here, for simplicity,
14
For a detailed analysis of this kind of problem, which considers several types of media of
exchange, see (Santomero and Seater 1996).
15
we collapse all the variables that affect the agents’ decisions into a single variable,
called ‘efficiency’ (π). The efficiency of a medium of exchange can be regarded as a
direct function of the degree of diffusion of the medium itself in the economy. Money
is an asset with a positive network effect: it becomes more useful (efficient) as its
diffusion in the economy (here denoted by its share of the total demand for money)
increases.
We can then write
δπ i ∂ 2π
π i = f (i ) > 0, 2 i > 0 (18)
δi ∂i
where πi denotes the efficiency of the medium i (i = c, d, m) and total efficiency as
π ( c, d , m ) = π c ( c ) + π d ( d ) + π m ( m ) (19)
The agents’ problem is to choose the vector (c*, d*, m*) that maximizes π(c, d, m)
subject to the constraints
c + d + m =1
c ≥ 0, d ≥ 0, m ≥ 0
Apart from the trivial case of m* = 0 (there is no demand for e-money), the
maximizing solution could be such that either the agents’ demand for currency, for
bank deposits, or for both is nil. If e-money requires conventional money for its initial
purchase, obviously either c or d must be positive,15 but both can be very small. In
such a case, the maximizing solution would imply a significant reduction in the
demand for conventional money.
This latter solution could be justified by the typical characteristics of e-money. As is

well known, currency is usually preferred to deposits because its cost of usage is
virtually nil whereas deposits have a positive cost (trips to the bank, fees charged on
them, etc.); on the other hand, deposits are safer than currency and make the payment
of large amounts easier. E-money, on its part, has both the advantages of currency and
deposits: its cost of usage is very low and, at the same time, is safer than currency. For
these reasons, e-money can be a very good substitute for both currency and deposits,
15
If the possibility that the use of e-money is totally independent of conventional money were
admitted, the maximizing solution could be the vector (0, 0, 1). Conventional money is completely
displaced by e-money.
16
and the public could maximize the efficiency of exchanges by demanding ‘very little’
conventional money.
However, because of network effects, e-money is more efficient than the other media
only if its degree of diffusion in the system is larger than a certain critical value of m.
The process through which conventional money is largely displaced by e-money can
be described in the following terms: e-money owns some characteristics that make it a
more efficient means of payment than conventional money, but this is true if e-money
becomes sufficiently widespread in the economy. Once the degree of diffusion of e-
money has reached this ‘critical’ value, positive network effects are able to induce a
large reduction in the demand for the other means of payment.
There can be, however, several factors at work that prevent e-money from becoming
the dominant means of payment in the economy. Dowd and Greenaway (1993)16 have
shown that, despite the existence of positive network effects, there can be obstacles to
the diffusion of a new more efficient means of payment. There can be some sort of
‘inertia’ that prevents the displacement of the less efficient means of payment. Such
inertia can be due to a high ‘switching cost’ (the cost implied by moving from a
means of payment to another) and to a problem of coordination: the new means of
payment is actually more efficient than the old only if it is adopted by a large number
of agents in the economy, but no single agent knows when and if the others are going
to switch to the new means, so that nobody (or very few) will adopt the new
instrument. The presence of inertia in the system means that, in many cases, the
degree of competition among different means of payment is not very strong. The
introduction of potentially more efficient means is not necessarily conducive to the
displacement (or ‘quasi-displacement’) of ‘inferior’ instruments.
Krueger (1999) has further elaborated on Dowd’s and Grenaway’s contribution. He

draws a more precise distinction between switching from one medium of exchange to
another and switching from one unit of account to another. In his opinion, network
effects are more relevant to the latter kind of switching. As for media of exchange, the
displacement of one by another is a less serious problem. Krueger argues that
different media can coexist. More precisely, different instruments can coexist when
16
Dowd and Greenaway are mostly concerned with switching from one currency to another, but
their analysis can be easily extended to the choice of competing means of payment.
17
they are perfectly convertible into one another at a fixed exchange rate of 1:1, as is the
case for currency and demand deposits (Krueger 1999, p. 18). From this Krueger
derives the conclusion that the highest probability for e-money to be introduced in the
system successfully is to have these characteristics, i.e. full convertibility with the
other existing media at a rate of exchange of 1:1. In this case, e-money can be
introduced and adopted successfully but it would coexist with cash and deposits. In
other words, there would be an ‘intersection’ between the old and the new system of
payments.
Thus, in principle, e-money, thanks to positive network effects, could largely replace
conventional money. However, a certain degree of ‘stickiness’ in the system is likely
to prevent such a process from taking place. Here, however, the problem of the
competition between e-money and conventional money has been examined without
considering the possibility that there are exogenous interventions (by governments or
central banks), either to prevent or to favor the diffusion of e-money. In reality,
central banks in particular can, and actually do, take a number of measures that make
the diffusion of e-money much less likely than it may be predicted from an abstract
model of maximization. We shall return to this aspect in the next sections.
5. The impact of e-money on the monetary system and

central banks
The current discussion on the monetary implications of the IT revolution takes place
in the context of a more general debate on the implications of financial innovation, in
which many monetary economists have been involved for the last 20-30 years. In
particular, monetary economists have recurrently been concerned with the problem of
the ‘future of money’, that is to say with the question as to whether the incessant
process of financial innovations is leading or not toward a world without money, or at
least money as we know it today.
In the early 1980’s, New Monetary Economics started this debate.17 The basic idea
behind this approach was that the significant reduction in transaction costs, brought
about by innovations in the payment system, makes it possible to have a world
without any medium of exchange and a unit of account different from conventional
17
Or BFH approach, from the names of the three main representatives of this strand of economics:
Black, Fama and Hall.
18
money. Transactions would be made through an accounting system, which works

through bookkeeping entries, debits and credits, while the role of unit of account
(numéraire) can be played by any good (asset) or bundle of goods (assets) (see, e.g.,
Fama 1980; Greenfield and Yeager 1983). In spite of some differences among them,
the representatives of the New Monetary Economics shared the common conviction
that a world without money18 would be more efficient and more stable than the
currently existing economies. In particular, this new world–with central banks much
less, if at all, powerful than today–would be free of inflation and instability.19
The debate on the future of money has recently acquired new vigor, especially in the
second half of the 1990’s. This later debate, inevitably, echoes many discussions of
the 1980’s, but with some distinctive characteristics. In particular, the different
attitudes toward the possibility that IT innovations bring about a significant
weakening of central banks’ power. On the one hand, for several participants in the
debate, the possible weakening of central banks is a matter of concern rather than as a
positive evolution of the monetary system. On the other hand, for others, IT
innovations do not really represent a serious threat for central banking and the
possibility to implement monetary policy. Below, this debate is briefly considered by
concentrating on the specific issue of the diffusion of e-money and its effects.
In the previous section we saw that the creation and diffusion of e-money can
determine either a decrease in the ratio of base money to total money; the diffusion of
e-money brings about a shrinking of the proportion of total money issued by the
central bank. To a large extent, the recent debate on the effects of the IT revolution
and e-money has centered on the issue of whether a significant shrinking of the
proportion of base money necessarily implies the weakening of central banks and
their ability to affect the economy as a whole through the interest rates. Nobody
18
That is to say a barter economy even though a sophisticated barter economy: ‘the BFH system is
(…) not a crude barter. People need not haggle over the particular goods to be accepted in each
transaction’ (Greenfield and Yeager 1983, p. 307).
19
‘No longer would there be any such thing as money whose purchasing power depended on
limitation of its quantity. No longer, then, could there be too much of it, causing price inflation, or
too little, causing depression, or a sequence of imbalances, causing stagflation. A wrong quantity of
money could no longer cause problems because money would not exist’ (Greenfield and Yeager
1983, p. 305). For a more detailed exposition of the salient characteristics of the New Monetary
Economics, see Krueger 1999. For a critique of some aspects of this theory see, for example,
Cesarano 1995.
19
seems to contemplate the case in which there is complete displacement of

conventional money.
Benjamin Friedman (1999 and 2000) is among those who are convinced that a
significant reduction in the demand for base money, in particular for banks’ reserves,
implies a corresponding decrease in central banks’ power. Although, already now, the
central banks’ open market operations are a very small proportion of total financial
transactions, they can still affect interest rates–and, hence, the economy–because their
transactions are fundamentally different from all the others: the central bank’s
purchases (sales) of securities always imply an increase (decrease) in the reserve
account of the seller’s (buyer’s) bank. No other participant in the market has the same
power to increase or reduce the total volume of reserves. The central bank is ‘a
monopoly supplier (and withdrawer) of reserves’. For example, when the central bank
reduces its supply of reserves, banks must reduce their supply of money to households
and firms. As households and firms compete with one another for the reduced supply
of money, the aggregate outcome necessarily is an increase in the interest rate
(Friedman 1999, p. 325). Thus, the central bank’s ability to control the rate of interest,
and hence implement monetary policy, crucially depends on the fact that there is a
positive demand for reserves or, more in general, for conventional money. For
Friedman, should this demand significantly shrink, the central bank would see its
power inevitably wane: ‘being a monopolist is of little value if no one needs, or even
wants, to have whatever the monopoly is of’ (Friedman 1999, p. 327).
The development of new technologies has largely contributed to the creation of many
possible alternatives to conventional money. One of those alternatives is e-money, the
diffusion of which implies a reduction in the public’s demand both for cash and bank
deposits.20 If the demand for deposits decreases, also the banks’ demand for reserves
at the central bank decreases, but banks can reduce their deposits at the central bank
also for other motives. Banks themselves could reduce their demand for reserves at
the central bank as new clearing systems might develop. Banks demand reserves at
the central bank essentially for clearing purposes, i.e. to settle inter-bank transactions,
but it does not have to be so for ever; competition can threaten this aspect of the
20
‘For most items, neither cash in one’s pocket nor an adequate balance in one’s chequing account
is necessary at the time of purchase. More recent improvements like electronic cash and “smart
cards” (…) have accentuated this trend’ (Friedman 1999, p. 327).
20
central bank monopoly power. Competition can come from the creation and
development of private clearing mechanisms (Friedman 1999, p. 333),21 which can be
favored by the IT revolution.22
As for e-money, Friedman points out that it does not displace conventional money
completely but, he argues, its adoption and diffusion in the economy could expand to
a point in which conventional money would be required only at the initial stage of the
value chain associated with transactions, i.e. to buy e-money. Moreover, if e-money
were issued by firms outside the banking sector, and third parties were willing to
accept balances on the non-bank firm’s books in payment for the firm that issues the
card, there would be no need for bank balances to back up in full its corresponding
liability. Transactions, in other words, would take place without using conventional
money (cash and bank money) at all and, hence, independently of the need for banks’
reserves at the central bank. In this way, e-money would develop to the point where it
is not merely a means of payment but also a means of settlement (Friedman, pp. 328-
9). In such a world, conventional money would still exist but the central bank’s power
is seriously impaired.
In Friedman’s terminology, the real threat to central banks’ power derives from the
possibility of a ‘decoupling at the margin’ of their operations from markets (Friedman
2000). In other words, conventional money could still exist, but with irrelevant effects
on the working of the economy as a whole. Decoupling at the margin can take place at
the quantity level and at the price level. From the quantitative point of view, there is
decoupling if, at the margin, changes in the balance sheet of the central bank become
less, or not at all, related to changes in the volume of assets and liabilities (money and
credit) actually needed by the public. From the prices point of view, there is
decoupling if the rate of interest set by the central bank becomes less, or not at all,
related to the rates and prices that are relevant for the economy as a whole (Friedman
2000, p. 263). In a world in which decoupling has taken place, the central bank can
still fix the yield of its own liabilities, but this variable is no longer connected to the
21
Even though, in this respect, central banks have still some advantage because they can offer more
guarantees than private clearing systems: ‘Most of the discussion of private clearing mechanisms to
date has focused on the risks that they present for a breakdown of the payments system in the event
of default, and as of today that prospect is certainly the more serious concern’ (Friedman 1999, p.
333).
22
See, e.g., (Palley 2001-2002, pp. 219-25), for a more detailed analysis of banks’ demand for
reserves.
21
interest rates and asset prices that are relevant for the economy as a whole. In other
words, the central bank would simply maintain its monopoly power over something
that is no longer demanded by a significant section of the economy, so that its
decisions become largely irrelevant.
To such evolution of the monetary and banking systems, the central bank could try to
respond by introducing new regulations that, for example, impose to e-money issuers
to have reserves with it. On the other hand, the issuers, in their attempt to avoid
regulation, could react with ‘product innovation’ (i.e. by creating new forms of
money). This is a ‘race the central banks might well lose’. If the ‘race’ were lost,
central banks would be left essentially with only their control of currency, which
anyway plays a less and less relevant role in advanced economies.
Although not considering e-money explicitly, King (1999) has taken a position that is
similar to Friedman’s: ‘there is no reason, in principle, why final settlements could
not be carried out by the private sector without the need for clearing through the
central bank’ (King 1999, p. 26). Once the central bank is no longer the institution
that manages final settlements, it has virtually lost all its power and could not
implement monetary policy (King 1999, pp. 26-7). Also Costa and De Grauwe (2001)
have recently expressed the opinion that in a ‘cashless world’, in which currency
issued by the central bank is replaced by privately issued liabilities, like commercial
bank deposits and e-money, and there are no reserve requirements, the central bank
would lose its ability to control the interest rate (Costa and De Grauwe 2001, p. 4). In
such a world, the central bank would be unable to force commercial banks to hold
deposits (reserves) with it; the central bank would be a bank like any other bank.
When the central bank, for instance, buys treasury securities from banks, there is an
increase in banks’ deposits with the central bank. In a ‘cash society’ this means the
creation of excess reserves that can be eliminated only through an expansion of credit
by banks. Things are different in a cashless world: banks’ deposits with the central
bank are just regular bank deposits and it is unlikely that commercial banks wish to
hold the full amount of such deposits in their asset portfolio. A large part of these
deposits will be presented for conversion at the central bank; which must liquidate an
equivalent amount of treasury securities. Therefore, the initial increase in the assets
and liabilities of the central bank is eliminated and the amount of liquidity in the
system can be expanded only to the extent that banks are willing to hold the liabilities
22
of the central bank; but, ‘since the central bank’s liabilities have lost their unique
character of constituting the cash reserves of the banks, it is unlikely that commercial
banks (nor any other agent) will be willing to hold these liabilities in significant
amounts’ (Costa and De Grauwe 2001, pp. 11-2). If central banks lose the ability to
vary the amount of reserves, they also lose the ability to affect interest rates.
Palley (2001-2002) has taken similar positions concerning the effects of e-money on
the demand for central banks’ liabilities. A wide diffusion of e-money would largely
reduce the demand for commercial banks’ reserves. At least part of the central banks’
power could be maintained by ‘inducing’ a significant positive demand for their
liabilities; for example by imposing that taxes are paid with conventional money and
that whoever chooses to exit the e-money circuit must be paid in conventional money.
These measures, however, could imply a reduction in the degree of the system’s
stability, as they can increase the risk of something like bank runs. In a situation in
which the public retains the option of demanding conventional money in settlements,
‘there will always be the risk that agents will switch and demand payment in such
form. If this happens, it will create a massive destabilizing liquidity shortage’ (Palley
2001-2002, p. 219).23
There have been several reactions to the sort of positions outlined above. The general
thrust of such reactions is that even a significant reduction in the demand for base
money does not imply a weakening of central banks’ ability to implement effective
monetary policies by fixing the (short-term) interest rate. Thus, the IT revolution in
general and e-money in particular do not represent a serious menace for central banks,
even though they may have to change the ways in which monetary policy is
implemented.
Although firmly convinced that e-money is not going to displace conventional money,
Goodhart (2000) has argued that even the disappearance of conventional money
would not reduce the power of central banks. As for the possibility that the demand
for currency should disappear, Goodhart insists on the fact that transactions made
with currency ensure complete anonymity whereas this is not true for exchanges with
e-money. Besides, e-money is not legal tender, so that ‘the demise of currency at the
23
See also (Palley 2001-2002, pp. 228-30) for the analysis of other possible sources of instability
created by the diffusion of e-money.
23
hands of information technology will not happen, at least unless an authoritarian

government should decree that it must happen’ (Goodhart 2000, p. 201).24 However,
apart from considerations on the actual possibility that e-money becomes widely used,
Goodhart argues that even the disappearance of conventional money would not reduce
the power of central banks.
Goodhart’s basic idea is that the central bank can retain its power to determine the
rate of interest because it is the government’s bank and, as such, it does not obey to
the logic of profitability (Goodhart 2000, p. 190). He assumes that e-money has been
actually adopted and used for payments. More precisely, Goodhart envisages the
following scenario. Individuals and firms hold accounts consisting of capital market
assets, which yield ‘e’ returns.25 A transaction between two subjects X and Y involves
a pre-programmed, computerized sale of some set of financial assets, or increase in
liabilities by X, and an equivalent pre-programmed investment by Y. In this situation,
we would have borrowers and lenders of e-money, with the (real) interest rate that, in
the long run, is determined by the ‘traditional’ factors, i.e. productivity and time-
preference. But, in the short run, the central bank can determine the (nominal) interest
rate. The central bank can set the rate of interest provided that the ‘e’ unit of
measurement in its country is different from the ‘e’ unit of measurement elsewhere
(Goodhart 2000, p. 203). With such a proviso, the central bank could, for example,
raise the rate of interest by raising the rate at which it lends e-money.
The central bank is always able to set the (nominal) rate of interest, regardless of
whether there exists or not conventional money: ‘Since the central bank’s credit rating
in its own “e” area, as the government’s bank, must be higher than that of any other
entity, it can mop up all excess liquidity by its bids for “e”. To do so, it cannot
immediately purchase other assets, since that would release the “e” liquidity back on
to the market. This means that its bids for “e”, e.g. by selling assets out of its
portfolio, may cause a reduction in its profits (or a loss). Unlike commercial entities,
though, the central bank–the government’s bank–can face a loss with equanimity. It is
this that gives it its power in the last resort to fix rates’ (Goodhart 2000, p. 205).
24
Since the social cost of using checks as a means of payment is high, Goodhart holds that e-money
might more likely replace check transfers rather than note transfers (Goodhart 2000, p. 200).
25
Financial assets are kept with a ‘custodian’ (not necessarily a bank), which does not issue
liabilities and does not lend. (Goodhart 2000, p. 203).
24
Banks know that the central bank is backed by the government and this also makes it
unlikely that it has to undertake large-scale open-market operations to achieve its
targets (Goodhart 2000, p. 205). It follows that the central bank’s power does not stem
from the fact that final settlements are made through it, i.e. through banks’ reserves.
In fact, all transfers are supposed to be settled with a custodian computer system.
Thus, information technology and e-money do not represent a radical menace to the
central banks’ power, as they maintain the ability to set the rate of interest.26
However, the question as to whether market economies should have a central bank
remains legitimate. The control of the rate of interest by the central bank can
determine a growing fiscal cost for the government, deriving from the fact that the
central bank must be ready to bear losses in order to set the interest rate. Such a cost
poses a general question of what benefits are produced by a central bank that
implements monetary policy discretionally, rather than on the basis of some
automatic, or semi-automatic, mechanism. In other words, for Goodhart, the debate on
‘free banking’ versus ‘central banking’, although in different terms from the past, will
continue mutatis mutandis.27
Also Freedman (2000) has held that it is unlikely for e-money to displace currency or
the current settlement services, but that even in the case of displacement the central
bank would be able to set or influence the short-term interest rate. The fundamental
reason why central banks have the power to implement effective monetary policies is
that commercial banks want to hold reserves with them, even though there is no
institutional reserve requirement. There are some important reasons why the central
bank is the privileged locus of settlements for banks’ payment imbalances: the central
bank is risk-free and can be lender of last resort; moreover, from when there were
reserve-requirements in all countries, banks are used to have reserves with the central
bank (Freedman 2000, p. 222).
Freedman analyzes the impact of e-money by making a distinction among three types
of new means of payment: access devices (ATM, etc.), which do not differ
26
Although IT innovations can reduce central banks’ seignorage revenues to a significant extent.
27
‘For the moment, the relative success of “independent” central banks in hitting their inflation
targets, without unacceptable side-effects, has muted this debate, but if such success should prove
transitory, the debate would reopen, whatever stage technology had reached. Central banks may
bring about their own demise by incompetence; they will be comparatively immune to technological
innovation’ (Goodhart 2000, p. 207).
25
conceptually from more traditional means of payment; stored-value cards (SVCs);

network money or pre-paid software products (Freedman 2000, p. 218). The second
type of e-money can be a substitute for currency, while the third can substitute
settlements on the central bank’s books. For Freedman, SVCs are not likely to
succeed because credit cards and similar means of payment have already captured the
market for middle-sized transactions. SVCs can succeed for very small purchases, so
that they can substitute currency but not bank deposits (p. 219).28 However, even if
SVCs replaced currency completely, the central bank could still influence the short-
term rate. It could issue interest-bearing bills and with the proceeds buy government
debt, so that it could keep on implementing open-market operations. Alternatively, the
central bank could impose reserve requirements on SVCs liabilities, or issue SVCs
itself (Freedman 2000, pp. 220-1).
It is network money that creates alternative ways to make settlements. A private bank,
for example, could act as settlement agent for all the others, but there are drawbacks
to this type of arrangement: a private bank is not risk-free; the other banks would be
uncomfortable about its competitive advantages. Another possibility could be that
banks settle payments by transferring risk-free instruments like treasury bills
(Freedman 2000, p. 223). In this case, however, there would be no lender of last resort
in case of shortfalls, so that banks would be obliged to hold large amounts of bills to
guarantee that they can meet their obligations. Moreover, keeping treasury bills would
be costly and, finally, they could become excessively scarce if the government’s debt
shrinks. Thus, Freedman’s conclusion is that banks will continue to use the current
system of settlement.
Freedman also asks the more general question whether it is really necessary to have
banks to transfer payments. Could the system evolve in such a way that final payers
and payees are connected directly through computers and no intermediation is
necessary? For example, a software company could offer payments transfer services
by using claims on itself as the medium of settlement or by using securities as the
means of transferring value. Freedman, however, observes that things would not
change substantially. In the first case, the software company would act as a bank and
there would arise all the risks connected to a private bank acting as a settlement
28
Moreover, SVCs issued by private firms would be riskier than notes issued by the central bank.
26
agency. In the second case, the use of securities to transfer values would have the
same drawbacks as in the case in which banks use bills to settle payments (Freedman
2000, p. 224). Thus, it is not clear why such futuristic system should be more
advantageous than the current one. In any kind of system, ‘what is essential is some
mechanism to limit risk, and there is no evident advantage to the proposed
mechanisms. Indeed, there are major disadvantages, except perhaps in a world in
which all assets are securitized, there are continuous markets, no end-of-day credit is
needed, and even small-value payments are settled with finality item-by-item. Given
the costs of such an arrangement, it is unlikely to arrive at it for a very long time, if
ever (Freedman 2000, p. 224).
But, even in such unlikely environment, the central bank could influence the rate of
interest. It could insist on the fact that the settlement of its own transactions is on its
own balance sheet and refuse to settle on alternative mechanisms, an arrangement that
would be more effective if the central bank continued to be the government’s banker
(Freedman 2000, p. 225). Alternatively, the central bank could continue to fix a
‘corridor’ for the overnight interest rate by providing standby facilities in which it is
prepared to accept overnight deposits at a certain rate of interest and to extend
overnight loans at a higher rate of interest. If market interest rates tend to fall below
the central bank’s deposit rate, market participants would choose to hold overnight
deposits with it (Freedman 2000, p. 225).
Woodford, in order to show that the IT revolution does not represent a real threat for
central banking and monetary policy, has developed a more technical and detailed
analysis of monetary policy under different regimes (Woodford 2000, 2001 and
2002). In particular, he considers cases in which there are reserve requirements
imposed by the central bank as well as cases in which there are no such requirements
and the limit case in which commercial banks reduce their demand for reserves
virtually to zero. First of all, Woodford argues that the crux of the problem is not the
possibility that the public’s demand for currency is even totally displaced by the
demand for some type of e-money. The possibility to implement effective monetary
policy is contingent upon the central bank’s ability to control overnight interest rates,
which are determined in the inter-bank market for the overnight banks’ balances held
27
at the central bank for reserve requirement purposes and for the clearing of
payments.29
Although deregulation (for example, the abolition of reserve requirements) and

innovations can determine a significant reduction in the banks’ demand for central-
bank balances, this does not mean that the central bank is unable to influence short-
term interest rates (Woodford 2001, p. 319). It can do so by paying an interest on
reserves. This method is followed by central banks that use a ‘channel’ system of
interest rate control (like Canada, Australia and New Zealand). With this system,
‘there is little reason to expect monetary control to be any more difficult following the
development of new electronic media for making payments’ (Woodford 2000, p.
244). With this sort of arrangement, there is no reserve requirement and banks still
hold reserves at the central bank as settlement balances. In a ‘channel’ system, the
central bank chooses a target overnight interest rate, supplies a certain amount of
settlement cash through open-market operations, and offers a lending facility by
which it is ready to supply any amount of additional overnight settlement cash at a
fixed interest rate, just above the target overnight interest rate’ (Woodford 2000, p.
245). Woodford’s conclusion then is: ‘Given a “channel” system for the
implementation of monetary policy (…), there is little reason to fear that either the
development of “electronic cash” for retail transactions or of alternative electronic
methods of settlement of payments among banks should threaten a central bank’s
ability to control the path of overnight nominal interest rates, and, through them,
spending and pricing decisions in the economy’ (Woodford 2000, p. 252).30
In the analysis of the functioning of the channel system, the banks’ demand for
deposits at the central bank is however positive, but Woodford also considers the
implications of possible, though for him unlikely, developments of payment systems
that do not require clearing through the central bank’s settlement balances. This
would amount to set a limit to the banks’ costs of clearing payments through the
central bank. If these costs went beyond such limit, banks would choose to abandon
the clearing system through the central bank (Woodford 2000, p. 254). If, for
29
The public’s demand for currency affects the rate of interest only to the extent in which it affects
reserves.
30
See also (Woodford 2001, pp. 325-41) for a detailed illustration of the working of the channel
system.
28
example, banks considered their balances with the central bank as useful as any other
equally riskless overnight investment, their demand for them would be nil at any
interest rate higher than the settlement cash rate and horizontal at any rate equal to or
lower than the settlement cash rate. In such a case, banks would hold balances at the
central bank only if the overnight rate is not higher than the central bank’s rate paid
on settlement balances. But the central bank could still control the equilibrium
overnight rate by fixing a positive settlement cash target, so that the only possible
equilibrium would be at an interest rate equal to the settlement cash rate (Woodford
2000, pp. 255-6; 2001, p. 343).
In this context, a perfect control of overnight rates should still be possible through
adjustments of the rate paid on central-bank balances and changes in the target
overnight rate would not have to involve any change in the settlement cash target, just
as is true under current channel systems’ (Woodford 2000, pp. 255-6). The central
bank can set the equilibrium overnight rate without any change in the quantity of the
balances held with it. Moreover, such constant supply of central bank’s liabilities can
be quite small, though positive, with respect to the aggregate volume of financial
transactions in the economy. This is possible because there does not exist an inherent
equilibrium value for a fiat unit of account like the ‘dollar’ (the central bank’s
liability), unless a particular value is determined through the monetary policy
commitments of the central bank itself (Woodford 2000, pp. 256-7).
In a completely deregulated context in which commercial banks do not settle through

the central bank, it might seem that it is impossible for the central bank to select
among alternative interest rates (and, hence, equilibria) through the monetary policy.
But this is not true because the unit of account in a purely fiat system is defined in
terms of the central bank’s liabilities. A contract promising to deliver a certain amount
of dollars at a certain date implies a payment in terms of settlement balances at the
central bank, or in terms of some kind of payment that the payee is willing to accept
as a suitable equivalent. In any case, ‘settlement balances at the central bank still
define the thing to which these other claims are accepted as equivalent’ (Woodford
2000, p. 257).
It is this factor that, for Woodford, explains why the nominal interest yield on
settlement balances at the central bank can determine market overnight rates. The
central bank can define the nominal yield on overnight deposits in its settlement
29
accounts as it wishes; it can also let banks exchange such deposits among themselves
at whatever terms they wish. However, the value of a dollar deposit with the central
bank cannot be anything other than a dollar. This is something that cannot be done by
private financial institutions.31 The special characteristic of central banks, therefore, is
that they are institutions whose liabilities are used to define the unit of account in a
wide range of contracts: ‘Even in the technological utopia imagined by the enthusiasts
of “electronic money”–where financial market participants are willing to accept as
final settlement transfers made over electronic networks in which the central bank is
not involved–if debts are contracted in units of a national currency, then clearing
balances at the central bank will still define the thing to which these other claims are
accepted as equivalent’ (Woodford 2001, p. 346).
However, even though it is true that the central bank can always fix the interest rate
on its deposits, would this rate be relevant for other market interest rates? Woodford’s
answer is in the positive: ‘Equally riskless short-term claims issued by the private
sector (say, shares in a money-market mutual fund holding very short-term Treasury
bills) would not be able to promise a different interest rate than the one available on
deposits at the central bank; otherwise, there would be excess supply or demand for
the private-sector instruments’ (Woodford 2001, p. 347). One could even imagine a
world à la Hayek, with competing monetary standards, and central banks would still
be able to control the exchange value of their currencies by adjusting the nominal
interest rate paid on their liabilities.
In such a world it would be legitimate to ask whether monetary policy still matters.
Woodford’s reply is that the relevance of monetary policy depends on how many
people would choose to contract in terms of the central bank’s liability. At the present,
it is costly for people to attempt to transact in a different currency from that issued by
their central bank; in a future in which all transactions costs have drastically reduced,
this might no longer be true. Nonetheless, it would still be convenient for contracting
parties to use a stable unit of account with a stable value. Therefore, central banks that
31
They can offer liabilities that promise to pay a certain amount of dollars in the future, but they
also must accept the market’s present evaluation of such liabilities. Even if these liabilities were not
perfect substitutes for other financial instruments, private financial institutions could not determine
both the quantity issued and the nominal yield, whereas the central bank can determine both the
quantity of settlement balances in existence and the nominal yield on those balances.
30
demonstrate to be able to maintain a stable value for their countries’ currencies should
continue to play a relevant role to serve in the future (Woodford 2000, pp. 257-9).
Friedman (2000) has reacted to the idea that the central bank could determine the
relevant interest rates in the economy even though the demand for its liabilities
shrinks to a very significant extent. In particular, he has objected to the positions put
forward by Freedman and Woodford, which we considered above. For Friedman, in
so far as the central bank is ready to lend to and borrow from banks in potentially
infinite volume, it can affect the entire structure of interest rates and influence the
working of the economy.32 In the actual world, however, central banks can implement
effective monetary policies without engaging in large transactions; it is so because
‘market participants know that, under current circumstances, the central bank can
make the interest rate whatever it wants–if necessary, by engaging in very large
transactions–and as a result those large transactions are not necessary. The market
watches the central bank’s signals, and then establishes–mostly on its own–the
interest rate level that the central bank seeks’ (Friedman 2000, p. 271). In other words,
the central bank can exert its power because the other players in the economy believe
that it has the strength to make to market work as it wishes.
It is basically for this reason, and not for those given by Goodhart, Freedman and
Woodford, that effective monetary policies can be currently implemented by central
banks. The present situation, however, could drastically change if players change their
conviction and, for Friedman, ‘with nothing to back up the central bank’s expressions
of intent (…), in time, the market would cease to do the central bank’s work for it.
This prospect is ultimately what the threat posed to monetary policy by the electronic
revolution is all about’ (Friedman 2000, p. 271).
***
We can draw some conclusions from the brief survey above of the debate on the
effects of IT and e-money on the working of monetary economies. First of all, it is
worth noting that all the participants in the debate stress that it is very unlikely for e-
money to become a widely adopted means of payment in the near future. There is also
a general consensus on the fact that e-money, if it will ever be widely used in the
32
‘Nobody should doubt that a large borrower or lender, willing to enter into transactions in infinite
volume, can set market rates’ (Friedman 2000, p. 269).
31
economy, will not displace conventional money completely. Complete displacement

cannot happen not only because e-money, at least in the forms currently known, must
however be bought with conventional money, but also because conventional money
remains a more efficient instrument for a more or less wide class of transactions (for
example those that take place in the black or informal economy). Finally, most also
agree on the fact that the crucial issue is not the possibility that e-money and IT
innovations determine a significant reduction in the public’s demand for currency
(cash). The crux of the problem is the effects of IT and e-money on the demand for
banks’ reserves at the central bank.
It is on this issue that the opinions of the participants in the debate diverge most
significantly. As we saw, Friedman is the most convinced that IT changes can have
relevant effects on the working of monetary economies and central banking. In his
opinion, a significant reduction in the demand for the central bank’s liabilities can
lead to what he calls ‘decoupling at the margin’, i.e. the impossibility for central
banks to affect the economy’s relevant variables. Palley introduces the further concern
for an increased degree of systemic instability, due to the diffusion of e-money.
Others, though they agree that e-money may reduce the demand for reserves, do not
believe that such phenomenon implies the impossibility for central banks to determine
interest rates and affect the economy as a whole. Woodford offers the most articulated
exposition of such position.
6. Conclusion
In this paper we adopted the ECB definition of e-money. According to this definition,
e-money requires the use of conventional money at the initial stage of the ‘value
chain’, i.e. to be purchased from the issuing institution, which can be either a bank or
a firm outside the banking sector. The diffusion of e-money generally implies a
reduction in the demand for base money, which is monopolistically supplied by
central banks. The impact of e-money on the central banks’ monopoly power tends to
be larger when it is issued by non-banking firms. In such a case, the reduction in the
banks’ demand for reserves is larger.
E-money has a number of features that, potentially, make it a more efficient means of
payment than currency and demand deposits. There exist, however, factors that are
likely to make the diffusion of e-money sluggish if not to block it altogether; in
32
section 4, we concentrated on the stickiness of the diffusion process due to costs of

switching and coordination failure.
The debate on the effects of e-money on the monetary system and central banking has
been carried out by referring to a notion of e-money that is consistent with the
definition of e-money adopted here. In particular, Friedman and others, who believe
in the possibility of decoupling, use a notion of e-money consistent with the ECB
definition: e-money is a device that must be pre-paid with conventional money–it
requires conventional money at its initial stage of the value chain. Those who have
objected to Friedman’s and others’ conclusions adopt a similar definition of e-money.
The idea that a large diffusion of e-money would imply a significant reduction of the
power of central banks and their ability to implement monetary policy in the
traditional ways appears to us more convincing. We believe that, for the reasons given
by Friedman and others, a significant reduction of the central banks’ monopoly power
would imply that their inability to implement policies in the ways envisaged, for
example, by Goodhart, Freedman and Woodford. However, we also believe that the
hypothetical situations outlined by Friedman and others do not own all the necessary
conditions for ‘decoupling at margin’.
If conventional money is required to buy e-money, it is problematic to conclude that

banks’ reserves are no longer necessary or that their volume becomes irrelevant. In
fact, conventional money should still be issued in significant amounts. A world
consistent with that envisaged, for example, by Friedman could be one in which all
transactions are made via e-money, which is bought initially by income recipients. In
this case, income recipients must be remunerated in conventional money. Therefore,
not only would conventional money exist but it would also be a relevant proportion of
the total supply of money. Firms should have deposits with banks to pay the factors of
production, which, on the other hand, would likely have deposits with banks that are
periodically transformed into e-money.
Decoupling would be more likely if the type of e-money used in the economy does
not presuppose at all the use of conventional money. For example, one could envisage
a world in which factors of production are directly remunerated in e-money, issued by
one or more firms, that is universally accepted as a means of payment in the economy.
More than 30 years ago, although in a different context, Kaldor had depicted a sort of
33
world without conventional money and virtually without any role to play for central
banks.33 He carried out a sort of mental experiment, by analyzing the effects produced
by a shortage of money. In a nutshell, his idea was that, if the central bank and
commercial banks are not ready to increase their supply of (conventional) money, any
excess demand for money would be filled by the creation of new means of payment
also in the form of non-bank money. There would emerge some money substitutes,
issued by firms or financial institutions. These substitutes would circulate in the same
way as bank notes do.
The system’s response to cash scarcity would be, on the one hand, an extension of
credit through a larger diffusion of credit cards and, on the other hand, the creation of
substitutes for cash.34
Any business with a high reputation (…) could issue such paper, and any one who could
individually be ‘trusted’ would get things on ‘credit’. (…) There would be a rush to join the
Diners Club, and everyone who could be ‘trusted’ to be given a card would still be able to buy as
much as he desired. (…) The rest of the population (…) who have no ‘credit’ (…) would get paid
in chits which would be issued in lieu of cash by, say, the top five hundred businesses in the
country (who would also, for a consideration, provide such chits to other employers). And these
five hundred firms would soon find it convenient to set up a clearing system of their own, by
investing in some giant computer which would at regular intervals net out all mutual claims and
liabilities. It would also be necessary for the member firms of this clearing system to accord
mutual ‘swops’ or credit facilities to each other, to take care of net credit or debit balances after
each clearing. When this is also agreed on, a complete surrogate money-system and payments-
system would be established, which would exist side by side with ‘official money’. (Kaldor 1970,
pp. 9-10)
In the present context, what is more interesting is the supply of ‘chits’ by non-bank
firms. These ‘chits’ are an actual alternative form of money; because the issuers also
create a clearing system, so that ultimate settlements do no longer require
conventional money. By creating a clearing system, the issuers do not even need a
banking system. In Kaldor’s example, this new money coexists with ‘official money’
but only because it is not used for all transactions and not because it needs at some
point in time ‘official money’. Kaldor’s world is one in which there actually is
decoupling in Friedman’s sense.
Thus, it is possible that technological and institutional transformations lead to a world

in which central banks have lost their power and their ability to implement effective
33
Kaldor’s interest in the possibility that there may exist alternative forms of money derived from
his criticism of the monetarist hypothesis of exogenous money and, hence, of the possibility to
control prices through the supply of money by the central bank.
34
Kaldor asked the rhetorical question whether it would be possible to prevent Christmas buying
sprees by constraining the supply of additional cash demanded by consumers.
34
monetary policies. The evolution of the monetary system in this direction requires,
first of all, that also e-money evolves into a means of payment that is substantially
different from e-money as it currently exists. The concrete possibility that advanced
economies evolve in this direction is contingent on the strength of the factors that we
have discussed in section 4. Moreover, central banks do not ‘sit back’ and watch
passively the spontaneous evolution of markets. Quite to the contrary, in order to
reduce the risk that financial innovations in general, and those brought about by the IT
revolution in particular, give rise to a system in which their power is largely reduced,
which is potentially more unstable because less controlled, central banks have been
keeping financial markets under close scrutiny and have taken several measures to
control their evolution.35
Central banks can try to introduce new regulations, or adjust those already existing, to
face the new situation. Moreover, they can make the use of conventional money
compulsory for certain classes of transactions (for example the payment of taxes) and
also impose that only ordinary banks can issue e-money. As we saw, ‘bank’ e-money
implies a lesser threat for the central bank’s power because it is not substantially
different from conventional money and it implies a positive demand for reserves;
therefore its effects on the working of the monetary system are less disruptive than
those produced by ‘industrial’ e-money.36 Finally, another possibility can be
considered. Little, if any, attention has been paid to the possibility that central banks
themselves become issuers of e-money. However, as we saw in the simplified context
of section 3 above, if central banks issued e-money, the economy as a whole could
enjoy the benefits of a more efficient means of payment without central banks losing
their power, but possibly increasing it. If, for example, e-money issued by central
banks displaced bank deposits, we would have a world in which only base money is
used and central banks are more powerful and effective in the implementation of
monetary policy.
35
A large number of studies and researches on e-money and its implications have been promoted or
carried out by central banks.
36
The ECB’s Report on Electronic Money (1998) is a good illustration of the typical ways in which
a central bank tries to limit the potential threats of e-money.
35
References
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Journal of Economic Behavior & Organization, Vol. 26, pp. 445-55.
Dowd, K., Greenaway, D. (1993) ‘Currency competition, network externalities and
switching costs: Towards an alternative view of optimal currency areas’,
Economic Journal vol. 103, pp. 1180-9.
European Central Bank (1998) Report on Electronic Money, Frankfurt.
Fama, E. F. (1980) ‘Banking in the theory of finance’, Journal of Monetary
Economics, 6, pp. 39-57.
Freedman, C. (2000) ‘Monetary policy implementation: past, present and future–will
electronic money lead to the eventual demise of central banking?’, International
Finance 3:2, pp. 211-227.
Friedman, B. M. (1999) ‘The future of monetary policy: The central bank as an army
with only a signal corps?’, International Finance 2:3, pp. 321-338.
Friedman, B. M. (2000) ‘Decoupling at the margin: the threat to monetary policy from
the electronic revolution in banking’, International Finance 3:2, pp. 261-72.
Goodhart, C. A. E. (2000) ‘Can central banking survive the IT revolution?’,
International Finance 3:2, pp. 189-209.
Greenfield, R. L., Yeager, L. B. (1983) ‘A laissez-faire approach to monetary
stability’, Journal of Money, Credit and Banking, vol. 15 no. 3, pp. 302-15.
Kaldor, N. (1970), ‘The new monetarism’, Lloyds Bank Review, July. Reprinted in
Kaldor 1978, pp. 3-21.
Kaldor, N. (1978), Further Essays in Applied Economics, New York: Holmes &
Meier Publishers.
King, M. (1999), ‘Challenges for monetary policy: New and Old’, Bank of England
Quarterly Bulletin, 39(4), November, pp. 397-415.
Krueger, M. (1995), ‘Towards a moneyless world?’, Working Paper no. 9916,
University of Durham, Department of Economics & Finance.
Palley, T. I. (2001-2002), ‘The e-money revolution: challenges and implications for
monetary policy’, Journal of Post Keynesian Economics, Vol. 24 No. 2, pp. 217-
33.
Santomero, A. M., Seater, J. J. (1996), ‘Alternative monies and the demand for media
of exchange’, Journal of Money, Credit, and Banking, Vol. 28 No. 4 (November
Part 2), pp. 942-60.
Solomon, E. H. (1997), Virtual Money, New York: Oxford University Press.
Woodford, M. (2000), ‘Monetary policy in a world without money’, International
Finance, 2:3, pp. 229-60.
Woodford, M. (2001), ‘Monetary policy in the information economy’, in Economic
Policy for the Information Economy, Kansas City: Federal Reserve Bank of
Kansas City, pp. 297-370.
36
Woodford, M. (2002), ‘Financial market efficiency and the effectiveness of monetary

policy’, in Economic Policy Review, Federal Reserve Bank of New York, vol. 8
no. 1, pp. 85-94.
37
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Claudio Sardoni – Alessandro Verde

THE ‘IT REVOLUTION’ AND THE MONETARY SYSTEM: ELECTRONIC

DIPARTIMENTO DI SCIENZE ECONOMICHE – Via Andrea Cesalpino, 12/14

types of e-money currently available. In section 3, we turn to a more detailed analysis

2. Money and e-money

Checks Electronic fund transfers (EFT)

Paper transfers Cards

1. e-money based on cards (multifunction pre-paid cards bought by buyers);

3. A simple model of the effects of e-money

The basic model without e-money

Let M1 be the public’s total demand for money, with

that denotes the demand for currency and

By denoting base money with H, from (1) to (3) we have

E-money issued by commercial banks (‘bank’ e-money)

Having defined e-money as a special type of demand deposit, it is natural to consider

The public’s demand for e-money is

The demand for currency and conventional deposits respectively becomes

The banks’ demand for reserves now is

and, therefore, the ratio of H to M1 becomes

Case 1. c1 = c and d1 < d (e-money is bought with deposits)

In this case, it is d1 = (1 − c − m ) and BEM can be written as

2. θ D > θ EM ⇒ BEM < B

3. θ D < θ EM ⇒ BEM > B

(demand deposits plus e-money) is necessarily positive and the ratio of H to M1 is

Case 2. c1 < c and d1 = d (e-money is bought with currency)

In this case, it is c1 = (1 − d − m ) and BEM can be written as

E-money issued by the central bank8

If the central bank completely substitutes e-money for currency,9 we have

Obviously, if m = c in (5), we have that BCB = B. The introduction of e-money is a

E-money issued by non-banking firms (‘industrial e-money)

Therefore, e-money issued by non-banking firms cannot be regarded as a component

The banks’ demand for reserves now is

4. The future of e-money

Such a conclusion, however, is not immediately obvious. In fact, e-money has a

We can then write

where πi denotes the efficiency of the medium i (i = c, d, m) and total efficiency as

This latter solution could be justified by the typical characteristics of e-money. As is

Krueger (1999) has further elaborated on Dowd’s and Grenaway’s contribution. He

5. The impact of e-money on the monetary system and

money. Transactions would be made through an accounting system, which works

seems to contemplate the case in which there is complete displacement of

hands of information technology will not happen, at least unless an authoritarian

conceptually from more traditional means of payment; stored-value cards (SVCs);

Although deregulation (for example, the abolition of reserve requirements) and

In a completely deregulated context in which commercial banks do not settle through

economy, will not displace conventional money completely. Complete displacement

section 4, we concentrated on the stickiness of the diffusion process due to costs of

If conventional money is required to buy e-money, it is problematic to conclude that

Thus, it is possible that technological and institutional transformations lead to a world

Woodford, M. (2002), ‘Financial market efficiency and the effectiveness of monetary

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