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implemented for mutual benefit and changed their relationship. Customers are now much
more integrated in the transaction process and may easily arrange their affairs through
the use of electronic commerce without having to be on site. Banks will be able to
reengineer business processes, offer new products and reduce personnel costs.




New Institutional Economics
There are many possible approaches to investigate different aspects of information and
communication technology and electronic commerce. This chapter chooses the perspec-
tive of New Institutional Economics, more precisely the Transaction Cost Approach,
which has been developed since the 1950s because of certain deficits in the Neoclassical
Theory. The criticism leveled is that the use of a market or of the legal system is neither
free nor without frictions (Williamson, 1990). On the contrary, institutions have to be
taken into account and transaction costs arise.
Ostrom (1990, p.51) states as follows:


“Institutions” can be defined as the sets of working rules that are used to
determine who is eligible to make decisions in some area, what actions are
allowed or constrained, what aggregation rules will be used, what procedures
must be followed, what information must or must not be provided, and what
payoffs will be assigned to individuals dependent on their actions.



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Reduction of Transaction Costs by Using E-Commerce in Financial Services 65


Transactions

The basis of the Transaction Cost Approach was established by Coase in 1937, who
questioned the reason for the existence of firms. He concludes that, “there is a cost of
using the price mechanism” during the transactional process between individuals. The
term “transaction” was introduced into the economic context by Commons (1990, p.58),
who reasoned:


Transactions [...] are not the “exchange of commodities,” in the physical sense
of “delivery,” they are the alienation and acquisition, between individuals,
of the rights of future ownership of physical things, as determined by collective
working rules of society.


Other authors do not limit the relevance to property rights. Williamson (1985, p.1) claims
that a transaction “occurs when a good or a service is transferred across a technologically
separable interface.” This definition will be the basis for all further discussion in this
context. Many differing points of view can be found, but there is at least agreement that
transactions are not free.


Transaction Costs

Arrow (1969, p.48) defines these specific costs in a very general way and found that
transaction costs are “costs of running the economic system,” whereas Williamson
(1989, p.142) considers them as the costs of “planning, adapting, and monitoring task
completion under alternative governance structures.” This latter explanation is the basis
for the development of the cost model and will be referred to later on when two
transactions are compared which are accomplished in various ways.
Transaction costs may occur in markets, within firms and corporations or in the political
framework (Richter/Furubotn, 1996). They may be fixed costs or variable costs. During
the transactional process, transaction costs are generated before, during and after the
actual transaction takes place (Coase, 1937). For example, costs of gathering information,
costs of preparing the transaction, costs of monitoring or contracting costs can be
distinguished in the different phases of a transaction. The specific amount of the
transaction costs accruing varies, and depends for example on the specificity of a
necessary investment in this transaction, on the frequency of occurrence or the
uncertainty in respect to environmental factors or the contractual partner. In the context
of all further investigations, uncertainty and opportunism can be excluded because the
analysis considers the contractual relationship between a financial institution and its
customers.




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66 Pfahler & Grebe


Quantification of Transaction Costs

After transaction costs have been identified and introduced as a new cost category, the
question is how to measure these costs and how to use them for economic analysis.
Different approaches can be found, for example from a macroeconomic or microeconomic
perspective. In addition, many case studies focus on certain markets or specific aspects
in or between corporations.
One of the most famous studies is the analysis of the development and importance of
transaction costs for the United States over a period of 100 years by North and Wallis
(1986, p.97). For them, transaction costs “are the costs associated with making ex-
changes, the costs of performing the transaction function.” All economic activities are
divided into activities which mainly transform input into output and those which are
basically involved in coordination and transaction processes. North and Wallis (1986)
demonstrate an increase of transaction costs of the whole transaction sector from 26.1%
to 54.7% of GDP between 1870 and 1970 and conclude that transaction costs are as
important as production costs in highly industrialised nations.
Demsetz (1968, p.35) focuses on the New York Stock Exchange (NYSE) and defines
transaction costs as “the cost of exchanging ownership titles.” He points out that these
costs decrease with an increasing trade volume and thus explains the concentration
processes at the NYSE.


Criticism

The most serious problem of the Transaction Cost Approach is the lack of a consistent
terminology. Even for a basic term like transaction costs there is disagreement about its
components, determinants and applicability for certain issues. Moreover, Niehans (1987)
points out that transaction costs “become difficult, perhaps impossible, to quantify.”
This lack of transparency is evident and basically the criticism is justified. But as the
Theory of New Institutional Economics and the Transaction Cost Approach are compara-
tively young disciplines in economic science, a fairly standardised terminology will
probably be developed in the future. Undoubtedly, transaction costs are relevant in
industrial nations and make up an increasing part of all costs caused by economic
activity. Last but not least, it is important to note that there is no imperative to measure
transaction costs absolutely or in a direct way. The approach developed in the next
section will link the Transaction Cost Theory to a specific subarea of Electronic
Commerce in Financial Services.




The Cost Model
The preceding sections have developed the conceptual framework for the target analysis
by defining the most important terms and by explaining the basic ideas. Now our own


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Reduction of Transaction Costs by Using E-Commerce in Financial Services 67


proposal to measure transaction costs will be introduced. We refrain from attempting to
quantify these costs in absolute terms but concentrate deliberately on relative consid-
erations. As the focus in this context is on the relevant interface between a bank and its
customers, internal and inter-bank transactions will be left out of consideration. Our
approach describes and illustrates a new way to combine the business perspective of a
financial institution and the personal perspective of a customer. As business modularity
can hardly be used to extend internal processes and to bridge the contrast between both
perspectives, the given theoretical framework used in Banking and Finance is insufficient
for the very specific investigation in this chapter: Only monetary factors have been
considered so far. This new approach includes monetary as well as non-monetary factors,
which are both covered by the underlying notion of transaction costs. The latter can
actually be more important and they may represent the major proportion of all the costs
that arise. Therefore, a relatively new framework to measure transaction costs has to be
developed.


Phases of a Transaction

In a first step, the transaction will be subdivided and classified into different phases
according to their evolution over the period under observation (Picot, 1982). Seven steps
can be well-defined:


Before a transaction can take place, certain preparations have to be made. To
initiate a bank transfer or a stock purchase, all necessary information has to
be collected. This phase is called “information seeking.” Afterwards, the form
has to be completed (“preparation”) by the customer. All details have to be
checked (“review”) before the instructions are forwarded (“transmission”)
from the customer to the financial institution. The latter has to verify the given
data (“inspection”) and starts processing the task. Subsequently, an order
confirmation is generated and transmitted back to the customer (“confirma-
tion”). The transaction is terminated when the customer has received this
piece of information and checked all of the particulars (“final checkup”)
(p.270).


Modes of Coordination

The model differentiates between seven modes of coordination. Each transaction can be
arranged in a traditional way by visiting a bank. Another possibility offered by most
European commercial banks is to send in a request by mail. Using a telephone to transmit
the required information, utilizing facsimile communication or interactive video-text
services are additional options. As a result of extensive technological progress, online
processing and mobile processing of transactions via the Internet is commonly used
nowadays.




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68 Pfahler & Grebe


Traditionally, a customer visits his bank during its office hours from time to time. He has
to leave his home to get there, and typing errors may occur while completing the form
manually. If he has to queue at the counter before it is his turn, the transaction may be
very time-consuming. The confirmation of the order completion will be received at the
next visit to the bank. A second alternative would be to post the order form by mail. Even
though there is still no device to protect a customer from typos, informal language and
errors, there is no need for him to go to his bank (which may be located far away) at a
certain time: The next postbox will do. A confirmation of the order completion will also
be received by mail several days later. By accomplishing a transaction via telephone it
is not necessary for a bank customer to leave his home anymore. Although it may be more
difficult to collect all information and to prepare the order, the transmission itself and the
generation of the order confirmation is partially automated and comparatively fast.
Telephone circuits can be used to transmit facsimiles and to receive information via
faxback, too. Most European banks offer or have offered this option for certain groups
of customers. No matter whether the order form is drawn up manually or by using a
computer, the bank has to review all instructions and enter them into the system.
BTX is the German version of interactive video-text. With regard to the stock market, it
is possible to receive and realize up-to-date market prices and to interact spontaneously.
Other information can be acquired easily and fast in comparison to the media mentioned
above, and error messages will occur in the case of typos in the electronic order form.
By using a computer with a connection to the Internet, a customer can initiate transac-
tions at home and is not restricted to office hours any longer. Typos and other errors will
usually be reported before the order form is transmitted electronically. The exchange of
information takes place instantly, the confirmation of the order completion will be
generated and received directly after the acknowledgement on the part of the bank. Most
services mentioned in the context of an online transaction are available for mobile
devices, too. The crucial advantage is the stand-alone aspect: No other equipment is
needed to seek information and to interact rapidly with markets from almost any location
at any time.
The verbal description of these reflections can be transformed into a qualitative ranking
on an ordinal scale. The matrix (Table 1) summarizes the potential relative reduction of
transaction costs and illustrates which technology has the largest impact on the process
described.




Table 1. Simple matrix for the phases in the transaction process and the mode of
accomplishment

No. Phase Manual Mail Phone Fax BTX Online Mobile

1. Information Seeking 0 0 0 0 +++ ++++ +++++
2. Preparation 0 0 - - 0 +++++ ++++
3. Review 0 0 + 0 +++ ++++ +++++
4. Transmission 0 + +++ ++ ++++ ++++ +++++
5. Inspection 0 0 + 0 +++++ +++++ +++++
6. Confirmation 0 + +++ ++ ++++ ++++ +++++
7. Final Checkup 0 0 0 0 0 0 0




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Reduction of Transaction Costs by Using E-Commerce in Financial Services 69


Enhancements of the Model

Although this table already reveals potential benefits and disadvantages of certain
technologies, its explanatory power is limited to ordinal statements. Assuming that the
chosen type of transaction costs can be measured on a relational scale, the values above
can be transformed into numerical values. Thus it is possible to introduce a simple scoring
model and to deduce more tangible conclusions than those derived from these first
ordinal assessments.
The aggregated value (AV) of a mode will be defined as the sum of all allocated part values
(PV) multiplied by their weightings (w). Each part value ranges from 0 to 1 and all part
values together sum up to 1. Below the formal description of the basic model is given:
m

‘ PV
(II) AV j = — wi
ij
i =1


(II) 0 ¤ wi ¤ 1


m
pi = 1
(II) i =1




The assumption is made that there are equal occurrences of transaction costs for bank
transfers and stock exchanges. No matter which of the two transactions is investigated
in the model, the same amount of costs (or reduction of transaction costs) is measured
for each combination of mode of coordination and phase of the transaction. In more
precise terms, the difference between a bank transfer and a stock purchase is the
importance of the specific phase in the evolution of the transaction as a whole. This is
taken into account by weighting the different steps according to their relevance in the
transactional process. Thus it is crucial for an order to be transmitted to the stock market
immediately, whereas a bank transfer may even take one more day without serious
consequences. Table 2 gives an overview of all assigned weightings.




Table 2. Phases in the transaction process and weightings for bank transfers and stock
purchases

No. Phase Weighting (Bank Transfer) Weighting (Stock Purchase)

1. Information Seeking 10% 20%
2. Preparation 15% 5%
3. Review 15% 5%
4. Transmission 20% 30%
5. Inspection 10% 5%
6. Confirmation 20% 30%
7. Final Checkup 10% 5%




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70 Pfahler & Grebe


Table 3. Enhanced matrix concerning stock purchases for the phases in the transaction
process and the mode of accomplishment
No. Phase Manual Mail Phone Fax BTX Online Mobile Weighting

1. Information Seeking 0 0 0 0 3 4 5 10%
2. Preparation 0 0 -1 -1 0 5 4 15%
3. Review 0 0 1 0 3 4 5 15%
4. Transmission 0 1 3 2 4 4 5 20%
5. Inspection 0 0 1 0 5 5 5 10%
6. Confirmation 0 1 3 2 4 4 5 20%
7. Final Checkup 0 0 0 0 0 0 0 10%


I. Sum (AV) 0.00 0.40 1.30 0.65 2.85 3.85 4.35

Potential Relative
II. 0% 9% 30% 15% 66% 89% 100%
Reduction of TAC




Table 4. Enhanced matrix concerning stock purchases for the phases in the transaction
process and the mode of accomplishment

No. Phase Manual Mail Phone Fax BTX Online Mobile Weighting

1. Information Seeking 0 0 0 0 3 4 5 20%
2. Preparation 0 0 -1 -1 0 5 4 5%
3. Review 0 0 1 0 3 4 5 5%
4. Transmission 0 1 3 2 4 4 5 30%
5. Inspection 0 0 1 0 5 5 5 5%
6. Confirmation 0 1 3 2 4 4 5 30%
7. Final Checkup 0 0 0 0 0 0 0 5%


I. Sum (AV) 0.00 0.60 1.85 1.15 3.40 3.90 4.70

Potential Relative
II. 0% 13% 39% 24% 72% 83% 100%
Reduction of TAC




For instance, information seeking and a rapid transmission to the financial institution
involved as well as a quick confirmation of a completed transaction is much more
important for stock purchases than for bank transfers. The latter may even take several
days before the final completion without serious consequences for any party.
Now that all necessary steps have been taken, the scoring model can be applied using
all assigned values and weightings. Advantages, restrictions and required technological
devices are summarized in one new enhanced matrix for each transaction (Tables 3 and
4), and each combination of a transactional phase and a mode of coordination has been
assessed and evaluated.
The total number of points acquired in the scoring model will finally be the basis for
additional conclusions on the relative percentages of potential reductions of transaction
costs.



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Reduction of Transaction Costs by Using E-Commerce in Financial Services 71


Session costs and insurance costs will always be limiting factors in mobile banking
deployment. Similar restrictions could be found for any other mode of coordination
mentioned in the chapter. Therefore, all reasoning is done on a relative basis. At this
point, the assumption is made that there is no relative reduction of transaction costs if
a transaction is accomplished in the traditional way without the use of technology (i.e.,
a manual transaction). Using the most sophisticated medium at a given point of time (i.e.,
mobile devices), a potential relative reduction of 100% can be achieved in comparison
to the remaining media. Specific potential relative reductions of transaction costs can
now be derived for all other modes in between.


Premises and Hypotheses

As models are created to simplify and to explain real coherences or circumstances,
premises may not be neglected. In this case, several simplifications have to be made:
• There are only the seven ways mentioned above to accomplish the transaction
• There is an absence of progress or new trends at the chosen point of time
• The same medium is used during the whole transaction process
• There are only two parties engaged, the bank and its customer
• The technical infrastructure has already been acquired and established
• The final result of each process is the same


In addition, several hypotheses are introduced, some of which will be referred to and
tested later on:
• There has been an enormous increase in the use of information and communication
technology in the last decade
• For this reason business processes have changed to a great extent
• For a national economy, the requirement for electronic commerce is the diffusion
of information and communication technology
• Customers act in a rational way and prefer those modes of coordination which help
to decrease the amount of accruing transaction costs
• Financial institutions are aware of these changes and the potential reduction of
transaction costs, and they offer new modes of interaction for their customers
• Relative reductions of transaction costs are decisive for the development and the
use of a new mode of transaction as well as the diffusion rates of the underlying
technologies




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72 Pfahler & Grebe


Criticism

The cost model developed in this section is limited to investigating and determining
transaction costs for a chosen area and for specific transactions only. Conclusions about
the amount of a reduction cannot be automatically transferred to other situations, and
there are several premises constraining its explanatory power. Furthermore, the utilized
scope of “transaction costs” involves monetarily measurable parts as well as non-
monetary components. As the deduction of reductions of transaction costs has been
conducted by the verbal description of processes, these steps may not be easy to
comprehend, nor unambiguous. As a matter of fact, two major weaknesses of any scoring
model are the assigned weights which can hardly be objectified and the compensatory
effects which may result from adding up all part values. Nevertheless, these aspects
apply for all different modes of transaction that have been investigated in this context.
Consequently, the scoring model enables comparative analysis to be carried out for
different modes of coordination. Changing the assigned values in a reasonable way
neither affects the general assessment of a single transaction in a significant way nor
does it have an impact on the general conclusions derived.




Empirical Considerations
Transaction costs have been surveyed indirectly in the cost model by comparing
different institutional designs. A similar approach will be taken in this section. Due to
the lack of data concerning the number and the volume of transactions actually
accomplished, further investigations will focus on the analysis of potential transactions
in most areas. Therefore, infrastructure facilities and institutional as well as technical
requirements will be reviewed for Germany.
The diffusion rates of certain underlying technologies which are necessary for electronic
transactions will give an idea of the resulting potential relative reductions of transaction
costs. Several regression models will be introduced and used to describe actual trends
and developments. The coefficient of determination (r2) serves as a measure to test the
quality of the applied model.
With regard to the banking sector, it is important to note that there has been a permanent
decrease in the number of commercial banks and branch offices in Germany over the last
twenty years (Figures 1 and 2).
From 1990 (4,711 institutions) to 2001 (2,696 institutions) there has been a decrease in the
number of commercial banks of about 42%. The regression model for this period predicts
2,087 institutions in 2010:


f(x)= -107,736x + 218635,905 and r2=0.9344




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Reduction of Transaction Costs by Using E-Commerce in Financial Services 73


Figure 1. Number of commercial banks in Figure 2. Regression models for the
Germany, 1980-2001 number of commercial banks in Germany,
1980-2001
Number of commercial banks




Number of commercial banks
year year




As shown in Figure 3 and 4, for this reason the number of inhabitants per commercial bank
has steadily increased (from 1,375 inhabitants in 1981 to 1,880 inhabitants in 2001).
Using the regression model for the period from 1993 to 2001, this number will have reached
2,199 by 2010:


f(x)= 41.517x-81249.894 and r2=0.9252



Figure 4. Regression model for the
Figure 3. Development of inhabitants
development of inhabitants per
per commercial bank in Germany, 1980-
commercial bank in Germany, 1980-2001
2001
Inhabitant per commercial bank
Inhabitant per commercial bank




year year




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74 Pfahler & Grebe


Figure 5. Development of telephone Figure 6. Personal computers per
mainlines in Germany, 1980-2001 Internet User in Germany, 1991-2001
Telephone mainlines (per 100 inhabitants)




Personal Computer/ Internet-User
year
year



Another indicator for the emergence of new technologies and the use of electronic
commerce is the number of telephone mainlines per inhabitant. These are required for
transactions via phone or fax and can be used to access the Internet. The number has
increased from 26 in 1980 to 61 in 2000 (Figure 5).


f(x)= 1.779x -3499 and r2=0.9812


The number of Internet users in Germany has grown from 0.3% in 1991 to more than 36%
in 2000. Today, more than one third of the population browses the net regularly or at least
from time to time. This fact and the enormous growth rate create a considerable potential
of customers which may accomplish bank transfers and stock purchases in the future.
The development of the number of personal computers per 100 inhabitants in Germany
since 1990 can be approximated by another linear regression model:


f(x)= 0.1398x -276,1 and r2=0.9877


A comparison between these data and the number of people browsing the Net may be
even more interesting. Figure 6 relates the number of available personal computers to the
number of Internet users. The latter increases much faster because not every single
Internet user owns a personal computer, several individuals can use one device to get
access to the Internet, and it is now possible to be connected via PDA (personal digital
assistant) or mobile phone, which are commonly used. The increase of mobile phones per
100 inhabitants in Germany can be approximated by the following regression model:


f(x)=0.45405x-904.25649 and r2=0.9863


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Reduction of Transaction Costs by Using E-Commerce in Financial Services 75


Figure 7. Number of online accounts in Figure 8. Regression model for the number
Germany, 1995-2001 of online accounts in Germany, 1995-2001




Online-Accounts (in millions) [log]
Online-Accounts (in millions)




year year



The number of online accounts has been increasing considerably over the past years as
the cost model has predicted (Figures 7 and 8). As bank transfers are highly standardized
and common transactions, they are processed via new media more and more often:


f(x)=0.47462x-946.55059 and r2=0.9766


Figure 9 displays the development of German security accounts. Figures on how these
accounts are administered have not been available. Since 1995, the number has increased
from about 16 million to 34 million. As the value of r2 indicates, the regression model does



Figure 9. Number of security accounts in Germany, 1995-2000
Security Accounts (in millions)




year



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76 Pfahler & Grebe


not describe current developments very well in this case, but the figures definitely reveal
an increasing interest in stocks and in the capital market. Most of the newly established
accounts are probably governed online or by using mobile devices:


f(x)=0.14315x-282.88639 and r2=0.8686




Future Trends
The increasing use of information and communication technology as the most important
requirement for electronic commerce has been documented in the last section. Most of
the predictions and hypotheses which could be derived from the cost model have been
tested, at least for Germany.
It has been pointed out that the banking sector is facing dramatic changes and that the
required infrastructure is constantly being improved. More and more individuals are
utilizing information and communication technology to change their way of executing
transactions”in financial services as well as in other economic areas. At present it is
possible to realize relative reductions of transaction costs of 89% by using online
banking instead of accomplishing a bank transfer in a traditional way, and to realize a
reduction of 83% by switching to online brokerage for stock purchases. Transaction
costs which commonly arise from the interface between a financial institution and its
customers are crucial. But the success of a new mode of transaction does not solely
depend on reductions of transaction costs: The diffusion rate of the underlying


Figure 10. Four quadrant scheme for the classification of present and future impacts
of electronic commerce on financial services




Manual Transaction
Transaction via telephone
Diffusion Rate of the Underlying Technology




Postal Transaction Online Transaction

Transaction via Fax
Mobile Transaction




Transaction via BTX




Relative Reduction of Transaction Costs




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Reduction of Transaction Costs by Using E-Commerce in Financial Services 77


technology is another key aspect. To enable further predictions of sectoral trends and
tendencies, all modes of coordination referred to are finally classified in a four-quadrant
scheme to illustrate present and future impacts of electronic commerce on financial
services (Figure 10).
Postal transactions and transactions via fax are inferior to other modes and will soon be
negligible. In Germany, BTX has already merged with online and Internet services.
Manual transactions will decrease, but they will still remain very commonly executed.
Until new modes of transacting are developed and accepted, online and mobile transac-
tions will continue to dominate other forms in this sector and gain even more importance.
Referring again to the famous study by North and Wallis (1986), it should be underlined
that transaction costs are of extreme importance nowadays and that they have been
increasing significantly over the last decades. This applies to a national economy as a
whole as well as to specific economic areas. The increase originates from the growing
complexity of business processes and transactions, the high level of the division of
labour and the growing number of possibilities to act and to interact in general. By using
Electronic Commerce instead of the so-called “traditional ways” of interaction, these
costs can be reduced and limited to a great extent, depending on the specific mode of
coordination. In the future, reductions of transactions costs will be made possible by the
spread and the use of new technologies and modern communication and information
facilities, i.e., by the development and the extension of an adequate technological
infrastructure. However, it will have to be an issue of further investigation to what extent
these costs can be reduced and in which areas new transaction costs will arise.
Differences in the development of certain countries and of specific sectors will then help
to illustrate and to understand the complex impacts of ICT.




Conclusions
The model developed in this chapter intends to explain how transaction costs can be
reduced by the use of electronic commerce and its underlying technologies. Its academic
background is the Theory of New Institutional Economics. Quantifying these costs and
the potential reductions of transaction costs in an absolute way has not been possible
in this context. Nevertheless, by comparing alternative institutional methods (Williamson,
1985) of accomplishing the same transaction, the model is able to illustrate specific trends
and general tendencies in the banking sector under certain premises. At present,
transactions which are accomplished by using mobile devices lead to a maximal relative
reduction of transaction costs, and newer modes of transacting dominate traditional
methods from this particular point of view. Some of these older forms have already been
discontinued whereas others may not disappear completely from business life. But
provided that all individual participants act in a rational way, they should lose more and
more of their former importance.
Hopefully, new quantitative as well as qualitative indicators will be developed in the
future to assess the emergence and the amount of transaction costs in a national economy
as well as for specific enquiries. For this purpose, information and communication


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78 Pfahler & Grebe


technology itself should contribute to a significant extent by making it possible to
acquire, process and analyse relevant data.




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permission of Idea Group Inc. is prohibited.
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Appendix

Table 5. Number of commercial banks and inhabitants per commercial Bank in Germany
(From Deutsche Bundesbank, 2002, Monthly Statistics and Reports on Banking, 1980-
2001)

Year Number of Commercial Inhabitants per Commercial
Banks in Germany Bank in Germany

2001 2,696 1,880
2000 2,912 1,777
1999 3,168 1,725
1998 3,404 1,687
1997 3,578 1,620
1996 3,675 1,593
1995 3,785 1,570
1994 3,872 1,548
1993 4,038 1,530
1992 4,191 1,533
1991 4,451 1,617
1990 4,711 1,433
1989 4,297 1,400
1988 4,429 1,385
1987 4,543 1,375
1986 4,662 1,368
1985 4,739 1,365
1984 4,798 1,367
1983 4,848 1,374
1982 4,930 1,374
1981 5,052 1,375
1980 5,355 n.a.



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Reduction of Transaction Costs by Using E-Commerce in Financial Services 81


Table 6. Number of telephone mainlines in Germany (From Eurostat, 2002, Database
NEW CRONOS, Table TEL4)

Year Number of Telephone Number of Telephone Mainlines
Mainlines in Germany per 100 Inhabitants in Germany

2000 50,220,000 61
1999 48,300,000 59
1998 46,530,000 57
1997 45,200,000 55
1996 44,200,000 54
1995 42,000,000 51
1994 39,900,000 49
1993 37,500,000 46
1992 35,800,000 44
1991 33,700,000 42
1990 32,000,000 40
1989 28,847,800 37
1988 27,823,200 36
1987 27,007,100 35
1986 26,189,300 34
1985 25,391,800 33
1984 24,420,600 31
1983 23,385,600 30
1982 22,571,600 29
1981 21,645,900 28
1980 20,535,000 26




Table 7. Number of personal computers in Germany (From Eurostat, 2002, Database
NEW CRONOS, Table PC1)

Year Number of Personal Number of Personal Computers
Computers in Germany per 100 Inhabitants in Germany

2001 29,000,000 35.3
2000 27,640,000 33.6
1999 24,400,000 29.7
1998 22,900,000 27.9
1997 19,600,000 23.9
1996 17,100,000 20.9
1995 14,600,000 17.9
1994 12,300,000 15.1
1993 10,200,000 12.6
1992 8,800,000 11
1991 7,500,000 9.4
1990 6,500,000 8.2




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82 Pfahler & Grebe


Table 8. Number of internet users in Germany (From Eurostat, 2002, Database NEW
CRONOS, Table INTERN2)

Year Number of Internet Number of Internet Users per
Users in Germany 100 Inhabitants in Germany

2001 30,000,000 36.5
2000 24,000,000 29.2
1999 14,400,000 17.6
1998 8,100,000 9.9
1997 5,500,000 6.7
1996 2,500,000 3.1
1995 1,500,000 1.8
1994 750,000 0.9
1993 375,000 0.5
1992 350,000 0.4
1991 200,000 0.3


Table 9. Mobile Phones per 100 Inhabitants in Germany (From Eurostat, 2002, Database
NEW CRONOS, Table TEL4)

Year Mobile Phones per 100
Inhabitants in Germany

2000 59
1999 29
1998 17
1997 10
1996 7
1995 5
1994 3
1993 2
1992 1
1991 1


Table 10. Number of online accounts in Germany (From Homepage of the BDB, 2002,
http://www.bdb.de/pic/artikelpic/062002/19-06-2002-Entwicklung-Onlinekonten
2001.pdf)
Year Number of Online
Accounts in Germany

2001 19,740,000
2000 15,130,000
1999 10,160,000
1998 6,960,000
1997 3,480,000
1996 1,800,000
1995 1,390,000



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Reduction of Transaction Costs by Using E-Commerce in Financial Services 83


Table 11. Number of security accounts in Germany (From Homepage of the BDB, 2002,
http://www.bdb.de/pic/artikelpic/122001/TzZ_Depots.pdf)

Year Number of Security
Accounts in Germany

2000 34,332,000
1999 25,194,000
1998 20,586,000
1997 18,304,000
1996 17,063,000
1995 16,303,000




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84 Kurihara




Chapter V



The Spreading Use
of Digital Cash and
Its Problems
Yutaka Kurihara
Aichi University, Japan




Abstract
It has been several years since the words “digital cash” and other related terms were
introduced. Although e-commerce has been growing, digital cash has not been a focus
of much attention. Digital cash has some problems associated with it that need to be
solved before its use can continue to grow. There are two points the author emphasizes
in this chapter. The first is that the essential characteristics of digital cash, its
advantages and disadvantages, should be carefully examined. The second point is
since financial institutions cannot stop this trend, it would be prudent for them to view
it as a business opportunity. Monetary authorities should pay careful heed to the trend
as well, guiding the “sound” market to maturity, taking care not to exercise excessive
intervention.



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The Spreading Use of Digital Cash and Its Problems 85


Introduction
It has been several years since the words “digital cash,” “e-money,” “e-cash,” and other
related terms were introduced to the modern lexicon. Needless to say, the progress made
in communication and information technology has been very rapid, and the area of digital
cash is no exception. The volume of such transactions is rising, yet there has been little
analysis of this revolution in payment, particularly in academic fields. Investigating the
influence and problems of this trend is an inevitable and important task, not only from
a practical standpoint but from a theoretical one as well.
Although e-commerce has been growing rapidly and attracting much attention, digital
cash has not been a focus of such attention. Digital cash has some problems associated
with it that need to be solved before its use can continue to grow, and the rate of growth
is slowing at present. We can say that digital cash is not used in practice. The logic behind
replacing cash, checks and magnetic credit cards with digital cash is bound to prevail in
the end but there are many barriers that need to be overcome.
In the past, I have classified digital cash into an electronic wallet type and an online type.1
I then proposed that material cost reduction and service price cutting2 were the resultant
factors of the demand for electronic wallet transactions and the means by which digital
cash could spread, the technology of IC card reformation could develop, and price
cutting on the supply side could occur. The popularization of the personal computer and
the Internet has also prevailed, as well as the stabilization in demand of Internet-based
commercial dealings as a key factor of development for online transactions on the demand
side. General price decline for media equipment, typically computers, has been ongoing
as well, helping to promote the online-type transaction at the supply side.
It is said that electronic commerce in the United States more than tripled from 1997 to 1999.
Moreover, it seems that the spread of mobile telecommunications such as cellular phones
contributed to the development of digital cash. In the near future, television, etc., will be
used to make transactions. IT (information technology) has undergone a global revolu-
tion in many fields. Ubiquitous instruments in IT fields appeared recently, allowing for
digital cash to develop much further.
The purpose of this chapter is to analyze the inter-relational characteristics of digital
cash, financial institutions, and financial authorities. Section 2 specifies the definition
of digital cash, including a new payment instrument, the debit card. Section 3 investigates
the advantages and the disadvantages of digital cash. Here I will address the problematic
aspects of digital cash that have been clarified through our ongoing experiments and that
are observable in society at large. Section 4 considers the connection between digital
cash and the financial institution. In section 5, I analyze the relationship of digital cash
to monetary policy and the decision making of the policy authorities. Finally, section 6
is a brief conclusion.




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86 Kurihara


What is Digital Cash?
It is difficult to actually define what “digital cash” is. The classification has traditionally
been either “IC card type (wallet use)” or “Network type (online use).” The IC card type
digital cash has the value in itself, while the network type digital cash is data maintained
on a personal computer or host computer (Figure 1). Recently, however, digital cash as
a combination of both types has appeared. The distinction between the two is murkier
than before.
Pertinent here are two forms of transaction: the “closed loop” and the “open loop.” In
a closed loop transaction, the transfer of the monetary amount is in the form of digital
cash. For instance, a purchaser applies for an issue of funds from a financial institution
(typically a bank), the digital cash is electronically transferred as payment for the
commodity or service purchased, and the seller (vendor, etc.) settles the transaction at
the value paid. This transaction is not transferable to any other users. The tools of the
closed-loop transaction are the IC card and network digital cash.
On the other hand, digital cash issued once is susceptible to being reused for subsequent
settlements in an open loop where revolving liquidity exists. This is a pitfall of the IC card

Figure 1. IC card type and network type


IC Card Type Network Type
Wallet Use; Online Use;




Smart Card or Cyber Money or
Stored Value Card Network Money




The value is encoded The value is maintained on
on the card a personal computer or
host




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The Spreading Use of Digital Cash and Its Problems 87


Figure 2. Closed loop and open loop


Closed Loop Open Loop




Not Transferable Liquidity Exists




The amount is in It can be reduced
digital cash subsequent
settlement




type closed loop transaction that is in the mainstream now (Figure 2). Cash can be reused
and divisible much more immediately while collection of non-cash instruments can be
delayed when drawn on non-local payer institutions (Hancock and Humphrey, 1998).
It would be worth pausing to consider whether digital cash is truly money. Though credit
cards, checks, debit cards, etc., have become remarkably widespread for making pay-
ments in electronic form, the differences between these and digital cash are important
ones (BIS, 1996). A lot of people are using a new batch of credit cards that can be acquired
online (Tringham, 2000). Such financial tools should not be classified as digital cash, and
from the standpoint of monetary policy the distinction is particularly important.
What I am focusing on here is a form of digital cash that builds information on “pseudo-
cash,” in other words the digital cash itself, into the card and the network, and transacts
with it. The entity of digital cash has these facets: a) a concluded settlement; b) non-
specificity (no defined purpose); c) the transfer; d) circulation (freely usable); and e)
anonymity. It is necessary to assign a concrete classification to digital cash as a legal
financial instrument unique and separate from deposit currency, time deposit, certificate
of deposit (CD), trust funds, etc., which must not be classified as digital cash. It follows
that the debit card, the pre-paid card, the credit card, and the check as listed above do
not fall under the digital cash definition in spite of being traded in electronic form.
The non-specificity of digital cash far exceeds that of other electronic monetary
instruments such as pre-paid phone cards. It is inferior to traditional cash and does not
exist in closed-loop transactions. The circulation of digital cash also is low now, and it



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88 Kurihara


is doubtful whether anonymity exists in the form of currency deposits. Also, digital cash
is not under the constraints of the laws governing traditional currency. However, our
stated examples fit within the realm of the above-mentioned definition and thus should
be classified as digital cash.




Advantages and Disadvantages of
Digital Cash
In this section, I analyze the advantages and the disadvantages of digital cash.


Advantages of Digital Cash

It is common knowledge that both types of digital cash have the advantage of reducing
the cost, the time, and the human-error risk of transactions for both the payer and the
payee.
Santomero and Seater (1996) argued that the amount of pre-paid values stored on
(including digital cash) products by households will be functions of the types of
consumer goods that can be purchased using them, the availability of terminals that
accept them, and the compatibility of competing digital cash products with each other.
Furthermore, Kane (1996) reasoned that time-of-day flexibility and the protection from
violent crime provided by electronic banking and TV shopping may be desirable services
that paper cash transactions simply cannot offer. Kwast and Kennickle (1997) have
illustrated that income, financial assets, age, and education all play important roles in
determining household use of digital cash products.
Due to the availability of the IC card, we do not need to carry much cash on our person
or deal with the annoyance of loose change. The IC-type transaction has the additional
merit of transaction privacy.
As for the network type transaction, not having to go to the scene of the purchase is one
key advantage. And there is high security against theft or loss. Furthermore, it allows
sellers to save on handling costs and increase business opportunities even if they
traditionally have a small-scale clientele. Low-cost transactions are highly likely as
cross-border business dealings increase. The cost of handling transactions electroni-
cally is approaching the level that makes even relatively small purchases with electronic
payment means feasible. Such non-paper exchanges can now have a cost advantage over
traditional payments.
Also stemming from this would be the proliferation of related commodities such as
computers and software, and the creation of a specific demand for such network
transaction services.
Banks (2002) defines digital cash as “an electronic currency, created through special
software, that can only be used on the Internet.” He also says that most online B2C



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The Spreading Use of Digital Cash and Its Problems 89


payments are handled through credit cards. Throughout the rest of the world payment
methods vary and include electronic payments, direct debits, and credit cards. While this
is cost-effective for most transactions, it is not efficient for smaller “micro” transactions.


Disadvantages of Digital Cash

Despite the bright prospects that digital cash can offer, the flip side of the digital coin
reveals some serious dilemmas. Here is a list of some important problems.
1) Who pays the cost of a digital cash system?
The cost of creating digital cash is high (Rosenblum, 1996). Because it is expensive
to invest in the advanced technology of the IC cards and equipment and to set up
the required minimum infrastructure, the commitment to this mode of transaction
must be authentic, official, and for the long term.
2) How are the users protected?
This is a legal question as well as an “economic and technological” one. A standard
has been emerging around the world that in online-type transactions, a debt
incurred from the fraudulent use by another person of one™s registered identity or
account is the sole responsibility of the registered owner3. Still, the U.S. Commerce
and Trade Code (Title 15, Chapter 41, Subchapter 6, Section 1693g) states that a
consumer™s liability for an unauthorized transfer shall not exceed a) $50, or b) the
monetary amount or value obtained in the unauthorized electronic funds transfer,
whichever is less. Japan™s commerce code has no equivalent safeguard at present.
3) Problems facing the issuing entity
What happens when the issuing entity experiences an emergency, along the lines
of bankruptcy for instance? In the case of the European Central Bank (ECB), it
assumes that the issuance of digital cash is the same as the acceptance of the
deposit for those who issue it. Thus the issuing organization should be limited
specifically to the financial institution in order to a) defend the settlement system,
b) protect the consumer, c) properly execute monetary policy, and d) promote
competition. It should be noted that there is some debate within Japan™s Ministry
of Finance about whether the issue of digital cash should be allowed via other
entities as well as traditional financial institutions.
4) Customer selection criteria
Aspects of customer eligibility could become more technology based. For in-
stance, being unable to use a personal computer could mean being denied certain
services. Users need to perform difficult and different procedures in order to
participate in it in some cases.
5) How and where would taxes be levied and what would be an appropriate global
standard?
It is feasible that taxation of digital cash could be circumvented. And neither the
World Trade Organization nor the U.S. has much will to tax network trading.
Elsewhere in the world, the stance on the issue varies.



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90 Kurihara


6) What could be done to combat high crime?
High crime such as counterfeiting will be significantly more difficult to pursue in
the digital financial realm than it has been traditionally (Winer, 2002). At the
consumer level as well there are a number of serious security concerns associated
with IC-type financial transactions, including the ease with which an IC card can
be lost or stolen, not to mention the possibility of its use in cash laundering, which
has been noted before. Despite the privacy advantage of using digital cash, IC-type
transactions are not all that widespread (Berger et al., 1996). But there is a serious
crime risk among network-type transactions because of the sheer volume of them4.
7) The issue of user privacy
Privacy is a difficult issue as it is inseparable from security. Hackers have also aimed
at collecting information and using it fraudulently. The principal drawback of e-
transactions is the lack of privacy features associated with traditional cash
transactions. The anonymity that can be achieved by dealing in cash is missing.
But blinding causes another problem. How does the bank identify double-spenders
if the coin-holder can™t be identified? Essentially, the balance between individual
financial privacy rights and legitimate law enforcement interests is a problem.
The battle that emerges is between the privacy afforded to a consumer by means
of anonymous digital cash verses the desire of law enforcement to ferret out crime.
The fact of complete anonymity guarantees that some money laundering will be
easier to pull off.




Digital Cash and Financial Institution
Management
Many banks in developed countries have adopted several kinds of Internet banking
services, and some financial institutions that specialize solely in Internet banking have
been established. The possibility of cost reductions in customer services, severe
competition, and a rapid increase in consumer use of the Internet have all contributed
to the boom in Internet banking5.
The spread of digital cash is understood to have brought about an evolution in financial
settlement. For one thing, no longer do we need to be physically present at a shop or a
bank or even an ATM. We are free from having key activities of our daily lives dictated
by the hours, the location, and the protocols of the business establishment. In this
respect, the advantage of digital cash is substantial, as described in the previous section.
Moreover, even with the extra costs of incorporating the system into our financial
institutions, economies of scale are such that a broad customer base is assured
(Davidson, 1997; Redman, 1997).
Several major companies have announced an interface standard to be used for bank
services that is expected to further reduce the construction cost of the digital system.
Moreover, a movement to recognize such a global standard is growing in the United



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The Spreading Use of Digital Cash and Its Problems 91


States. I can imagine, then, the possibility that some new types of financial settlements
not dealt with by the banks will emerge with the spread of digital cash. In Japan such new
transactions are being realized today. With regard to this, non-banking institutions pose
a threat to banks and other traditional financial institutions. It is certain at least that the
trend will push down cash handling costs (Timewell, 1996), and the following may also
develop as symptomatic of financial industry digitization:
1) Overall decrease in the number of bank branches and staff.
2) Banks with fewer of their own branches (commercial mega-banks and some trust
banks, etc.) have an advantage (Orr, 1997; Cline, 1998).
3) A reduction in service fees in the case of net settlements or immediate settlements
(The Banker, 1997), as well as through use of one™s personal computer for banking
transactions.
4) By the acquisition of business information concerning commercial distribution, a
bank has the means to create a monopoly.
5) When institutions other than banks join the settlement network, it increases the
possibilities of systemic risk.
6) Likely to occur are tie-ups with credit-card companies and similar institutions
having their own set infrastructures (Business Week, 1995).
7) Shifts in these types of risks are forecast. Rather than the traditional concerns such
as interest rates, liquidity, and market fluctuations being at the center of attention
(Basle Commitment on Banking Supervision, 1998), operation risks may become the
focus. Having to lower the cost of information acquisition while globalization
continues to influence worldwide business trends makes it difficult for banks to
establish a central standard of technology and risk-management operations6.
8) If competition turns severe, confidence and reputation become more important
than before.


Each is trying to provide a better way of streamlining digital payments or replacing cash.
Of course, some new trend in the financial realm will have a ripple effect. There is the view
that any move to ensure that banks are not deprived of their vested right to profit from
certain transactions, for instance, would disturb the development of electronic banking.
Paper-based transactions are still the mainstay, according to Humphrey and Pulley
(1998), BIS (2000), and Weiner (2000), not only in the United States but in the other
countries as well.
Banks have a vested interest in keeping payment systems as slow as possible ” the
longer money takes to get from one bank account to another, the more use can be made
of it. This is why banks are not pioneers when it comes to more efficient ways of making
payment. Yet if they do not establish a relationship with the new payment schemes, they
risk losing their franchise (Shirreff, 2001).
New banks entered the market for merchant acquisition and a price war broke out,
reducing profit margins. All sorts of banks now complete fiercely to act as acquirers for
individual traders (Revell, 2001).




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92 Kurihara


Recently, digital cash helps to buoy the current bank merger wave (Solomon, 1999).
Mergers may pool risks and make it easier to launch successful credit card or electronic
cash operations just by capturing the infancy of less risk.




Digital Cash and Policy Authorities
Digital cash or the Internet payment has excited economists to speculate whether any
of the possible forms of money will make the present methods of operating monetary
policy impossible or much difficult. It is easy to predict that digital cash will influence
policy authorities. However, digital cash is seen as a bank-issued debt, or in other words,
a deposit. It circulates under the assumption, the trust, or the guarantee that 100% of it
can be converted to cash (a central bank note). The digital cash itself does not possess
the finality of the settlement. I doubt that the policy authorities will be greatly influenced
by it anytime soon. The mechanism of digital cash essentially is no different than a bank
note7.
How the policy authorities might be influenced by the appearance of digital cash is laid
out in the following:
a) Problem concerning management of the cash supply
I will discuss this problem in some detail. The debate continues about difficulties
managing the cash supply because settlements with deposit currency will decrease
as settlements by digital cash increase (BIS, 1996). So there are fears that the
function of deposit creation will decrease. However, there would be no change in
the cash supply if the issued digital cash were to be converted immediately to
traditional currency. Or if non-depository digital cash issuers hold their digital cash
in their own checking account, the cash supply will not be altered (Congressional
Budget Office, 1996; Hancock and Humphrey, 2000). The problem might instead
reside in what the monetary amount is and the length of time it is kept as digital cash.
For instance, there would be no change in the multiplier if the digital cash is issued
against a bank deposit, but the multiplier increases if digital cash is issued against
a treasury bond, for example. Moreover, it™s feasible for the multiplier to become
unstable at the diffusion interval of digital cash. However, in the case where digital
cash is increasingly substituted for paper cash, authorities would better be able to
manage high-powered cash. And regarding the national debt as well, it would
not be particularly difficult for monetary authorities to gain better control of
finances.
Then what would happen relating to deposit payment preparation? The effect of
the multiplier exists as long as demand continues for the cash that the central bank
issues or prepares for deposit payment. However, as digital cash prevails, the
comparative ratio of deposit payment preparations shrinks. Though the spread of
digital cash naturally decreases the preparation requirements for payment, the




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The Spreading Use of Digital Cash and Its Problems 93


multiplier rises and so does the possibility of the trend having an effect on monetary
policy.
There is a possibility that a rise in the inter-bank market interest rate would rise
because of a lack of deposit payment preparations. It can also be assumed that the
confidence multiplier could expand to infinity, because a legal preparation frame-
work does not currently exist. However, since a) the issuing body handles payment
preparation, b) part of it is converted into cash and a deposit, and c) the lending
demand is limited, the independent acceleration of such a movement may not occur.
The interest rate elasticity of cash-card substitution is a function of the level of
digital cash adoption in the economy and this elasticity is high at low interest rates.
This may result in perverse effects from attempts to contract (expand) bank credit
and liquidity by raising (lowering) interest rates.
Finally, when the digital currency of one country is converted into the digital
currency of another, cash-supply management becomes difficult.
b) Problem of cash demand
The function of cash is as a) a value standard, b) a payment instrument, and c) a
stored value. Digital cash is viewed as chiefly functioning as a payment instrument.
Tobin™s “stock theory” is useful when thinking about this. The cost of going to
a bank, changing a deposit into cash, and the cash demand are positively
correlated. If I apply this theory, then it follows that digital cash decreases the cash
demand. However, it is true that liquidity will rise, so digital cash has the possibility
of making the overall cash demand unstable.
The influence of digital cash was considered from the cash-supply side and from
the demand side in a) and b) of this section. Then, the shift of the multiplier and
the cash demand that may result cannot be predicted accurately. At this time, what
should policy authorities do? According to standard economic theory, if the shock
of the economic fluctuation is real, stabilizing the amount of the cash supply rather
than the interest rate reduces the breadth of the shift in real GDP. Conversely if the
shock to the cash demand is large, stabilizing the interest rate rather than the cash
supply reduces the change in real GDP (Poole, 1970). Therefore, when an unantici-
pated cash shock occurs in the market in the guise of digital cash, financial
authorities should stabilize the interest rate.
There has been much discussion about whether monetary authorities should give
precedence to controlling the cash supply (or the exchange rate) as an intermediate
goal over attaining price stability or economic growth. A typical example in which
the cash supply has been targeted as the intermediate goal is Germany (Gerlach,
1999). However, if authorities adopted such an approach, their control over the
cash supply would disrupt the stable relationship between the cash supply and
inflation, and thus economic growth as well. So it appears preferable for monetary
authorities to control interest rates instead of the cash supply in the digital cash
environment. Woodford (2000) says macro-economic stabilization depends only
upon the ability of central banks to control a short-term nominal interest rate.




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