Page 97 - Azerbaijan State University of Economics

Nazim Hajiyev, Daniyar Aliyev: A DSGE Framework For Sovereign Digital Currency
Adoption in Small Open Economies: Macro-Financial Channels, Bank Intermediation, and
Policy Trade-Offs

Keywords: SDC, CBDC, Small Open Economy, DSGE, Bank Intermediation.

JEL codes: E52, E44, F41, G21

INTRODUCTION
The possibility that central banks will issue sovereign digital currencies (SDCs), i.e.,
general-purpose digital central-bank liabilities available to households and firms, has
generated intense macroeconomic and financial debate. Theoretical work shows that
SDCs can expand liquidity services and discipline bank deposit market power
(Fernández-Villaverde et al., 2021; Burlon, Muñoz and Smets, 2024), but may also cause
bank disintermediation and contraction in bank lending unless design choices and central-
bank balance-sheet actions compensate for funding shortfalls (Infante et al., 2023).

Note: “DSGE” = Dynamic Stochastic General Equilibrium; “SDC” = Sovereign
Digital Currency; “CBDC” = Central Bank Digital Currency; “UIP” = Uncovered
Interest Parity; “NFA” = Net Foreign Assets. All acronyms are spelled on first use.

International and policy authorities emphasize that design — interest provisioning,
holding limits, tiering, and recycling of liabilities — is crucial for outcomes (BIS,
2021; IMF, 2023; IMF, 2025b). Small open economies face particular vulnerabilities:
shallower banking sectors, higher deposit reliance, and greater sensitivity to cross-
border capital flows make SDC design choices potentially more consequential than in
large, closed economies. Motivated by these considerations, this paper builds a
tractable DSGE framework that explicitly models: household payment demand across
instruments; monopolistic banks that intermediate deposits into loans; a central bank
issuing SDC with explicit recycling rules; and an external sector that transmits SDC
adoption through uncovered interest parity and cross-border flows.

Our contribution is threefold. First, we introduce a compact, analytically tractable
small-open-economy DSGE framework that explicitly models household payment
demand, monopolistically competitive banks that intermediate deposit into loans, and
a modular SDC design space (remuneration, tiering, cross-border usability) together
with central-bank recycling rules and balance-sheet responses. Second, we derive both
decentralized and planner equilibria and obtain closed-form comparative statics and
welfare expressions that identify parameter thresholds (for remuneration, tiering and
recycling) under which SDCs raise or reduce welfare. Third, with attention to the
small open-economy context, we show how exchange-rate and capital-flow channels
amplify intermediation trade-offs and demonstrate which policy levers—modest or
tiered remuneration, explicit holding limits, and credible recycling commitments—
are most effective at mitigating lending losses without surrendering liquidity-service

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