The digital pound, or central bank digital currency, would be issued by the Bank of England and would be interchangeable with cash for everyday payments in-store and online by businesses and individuals.
In a statement, the Treasury was keen to stress no decision has been taken at this stage to introduce a digital currency, and that this consultation is separate to its plans to legislate to protect access to cash.
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But the consultation starts from the position a digital pound is likely to be needed in the future.
A decision about whether to go ahead with a digital pound will be taken around the middle of the decade, based on future developments in money and payments, the government said.
The earliest stage at which the digital pound could be launched would be the second half of the decade.
The Bank of England will research the idea, and the public are being invited to give their views on the scheme.
According to the Treasury, its digital currency plans are to ensure the public have access to safe money that is convenient to use in a digital world.
The government also said the consultation is to support private sector innovation, choice and efficiency in digital payments.
Chancellor Jeremy Hunt said: "While cash is here to stay, a digital pound issued and backed by the Bank of England could be a new way to pay that is trusted, accessible and easy to use.
"That is why we want to investigate what is possible first, whilst always making sure we protect financial stability."
Andrew Bailey, governor of the Bank of England, added: "As the world around us and the way we pay for things becomes more digitalised, the case for a digital pound in the future continues to grow.
"A digital pound would provide a new way to pay, help businesses, maintain trust in money and better protect financial stability."
The consultation and the further work the Bank will now do will be the foundation for what would be "a profound decision for the country on the way we use money", Bailey said.
Digital money under the government's plans would replicate the role of cash in a digital world. So £10 of a digital pound would always be worth the same as £10 of cash.
It would be issued by the Bank of England, but neither government nor the Bank would have access to personal data and holders would have the same level of privacy as a bank account.
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The Bank would provide the central public infrastructure in the form of a ‘core ledger' - a secure technology platform - which would provide the minimum necessary functionality.
Regulated private firms could then use this to design user-friendly services and handle all customer-facing interactions.
Digital cash would be accessed through digital wallets offered to consumers by the private sector through smartphones or smartcards.
Consumers could use it for payments, online, in-store and for friends and family, rather than savings, with no interest paid on holdings.
Initially, there would be restrictions on how much an individual or businesses could hold.
Unlike cryptoassets and stablecoins, the digital pound would be issued and backed by the Bank of England and not the private sector.
This means, according to the government said, it will have intrinsic value and not be volatile, unlike unbacked cryptoassets.
The needs of vulnerable people are being considered in the digital pound design process, to make it simple and straightforward to use and understood and trusted by the public as a form of money.