Page 99 - 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

Working papers, and policy-oriented surveys within them, synthesize these model-
based findings and emphasize that design choices (remuneration, tiering, caps, and
recycling) and operational constraints matter crucially for the banking system and
monetary transmission. See BIS and recent central bank working papers for an
overview.

Banking, deposit substitution and financial stability
Our model builds on theoretical literature on deposit demand, bank intermediation and
fragility. Classic works on liquidity provision and runs (Diamond and Dybvig)
motivate modeling deposit convenience and the role of banks as liquidity
transformers. Recent papers on CBDC emphasize that even moderate remuneration or
increased convenience can induce deposit substitution, raising banks’ funding costs
and affecting lending (e.g., Keister & Sanches; Fernández-Villaverde et al.). This
literature motivates our modeling of deposit demand elasticities and the bank pricing
FOCs.

Small open economies, capital flows and exchange-rate transmission
Small open economies face distinct constraints—higher deposit reliance, shallower
capital markets, and stronger sensitivity to cross-border capital flows—which can
amplify SDC-induced effects. Empirical country-level studies in Economic Sciences:
Theory & Practice document exchange-rate pass-through and the structure of bank
deposits in small open economies; for Azerbaijan and comparable economies,
Rahimov and Jafarova (2021) document strong exchange-rate pass-through to CPI
components, motivating our open-economy treatment and the emphasis on central-
bank reserves and recycling.

Policy and applied work in the same journal discuss digital currencies and stablecoins
in regional practice; Taghiyev et al. (2021) analyze stablecoins’ institutional features
and contrasts to fiat liabilities, which helps motivate the tiering and interoperability
parameters in our design space.

MODEL
We present a log-linearizable New-Keynesian DSGE model with a banking sector and
SDC. Time is discrete and infinite, = 0,1,2, … . All agents are price takers except
monopolistically competitive firms and banks where specified. Lower-case letters
denote logs when variables are log-linearized.

Households
A representative household maximizes expected discounted utility:

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