We study economies where government currency and electronic money,
drawn from interest bearing deposits in private financial intermediary institutions,
are full substitutes. We analyze the impact of competition on policy outcomes
under different assumptions regarding: the objectives of the central bank, the
ability of the monetary authorities to commit to future policies, and the legal
restrictions—in the form of reserve requirements—on financial intermediaries.
Electronic money competition can discipline a revenue maximizing government
and result in lower equilibrium inflation rates, even when there is imperfect
commitment. The efficient Friedman rule policy, of zero nominal interest rates,
is only implemented if the government maximizes households preferences, in
which case, electronic money competition may either have no role, or weaken the
incentive effects of the “reputational mechanism.” We also show how an
independent choice of the reserve requirements can be an effective policy rule to
enhance the disciplinary role of electronic money competition.