I was reading a short publication from the Swedish central bank about the ongoing transformations of payment systems. It contained the following text (translated by me):

Central banks have a particular responsibility to ensure the financial infrastructure works well. The central bank mission of price stability […] presupposes that the financial infrastructure is safe and effective. There’s a mutual dependency between these two missions. Price stability contributes to making the Swedish krona attractive for payments within Sweden. That the Swedish krona is in use, in turn, is a prerequisite for the ability of the central bank to enact monetary policy […]. If the Swedish krona is not used for economic transactions, the central bank loses the tools they need to fulfill their mission.

This was quite insightful! The simple story says that as long as a currency is required for taxes, there will be demand for that currency, thus that currency will be useful for transactions. Under this model you would think it’s possible to legislate use for a currency by requiring it to pay taxes.

However, tax payments are of course a fairly small fraction of the transactions that happen in an economic region. If the Swedish krona was difficult to use, one could imagine that taxes were paid in sek but virtually all private transactions were made in eur. In that instance, the Swedish central bank would have no control over price stability, because they have no control over the euro, which would be used for the majority of transactions.

In other words, as the publication states: central banks can enact monetary policy because they are a popular alternative, and they are a popular alternative only as long as they do their job well.

That central banks do their job well is the real reason they have the power to enact monetary policy, not that the currency is required for taxes.

I hadn’t thought of that before.