Kozo Yamamoto, head of the Liberal Democratic Party's (LDP) council on financial affairs, said the BOJ risked being overtaken by private players who could launch their own digital currencies that could undermine the yen.
"If something too convenient pops up from the private sector, people might start to doubt whether they need yen as a currency unit. We must prevent this from happening," he said. "This is fundamentally about protecting Japan's currency sovereignty."
Yamamoto said he would prod the government and relevant agencies to speed up efforts to draft a revised BOJ law and other necessary legislation for issuing central bank digital currencies (CBDC).
However, more broadly, Yamamoto has been a vocal advocate of making changes to the BOJ law, which sets out the central bank's mandates.
Revising the law to include digital currencies would also present a good opportunity to make other changes such as adding an inflation target and job creation to the mandates, much like the U.S. Federal Reserve, he added.
"The new law should also clarify that 2% inflation is the BOJ's policy target," he told Reuters.
The BOJ does currently set 2% as its inflation target, introduced in 2013. But the target is not stipulated under the BOJ law, which says only that its role is to ensure Japan's price moves and financial system are stable.
Central banks globally have been reviewing their strategic goals, with the European Central Bank widely expected to follow in the footsteps of the Fed in aiming for inflation of 2% on average, meaning that periods when prices grow too slowly can be compensated for with faster increases at another time.
Central banks began looking closely at digital currencies after Facebook last year announced its yet-to-be-launched digital token Libra that would be backed by a mixture of major currencies and government debt.
Japan has been cautious about moving too quickly on digital currencies given the social disruptions it could cause in a country that has the world's most cash-loving population.
But China's steady progress toward issuing digital currencies has prompted the government to reconsider, and pledge in this year's policy platform to look more closely at the idea.
Other major central banks have also accelerated studies on CBDCs, given the recent rapid innovation in financial technology.
The BOJ said on Friday it would begin experimenting in the next fiscal year on how to operate its own digital currency.
Yamamoto said the BOJ's timeframe was "too late," adding that the first phase of tests should begin during the current fiscal year to March 2021.
CBDCs would also help regional banks, reeling from shrinking margins due to years of ultra-low interest rates, by allowing them to offer financial services at a lower cost and with less branches, Yamamoto added.
"I don't think we need to worry about any financial stability risks from issuing CBDCs," he said.
(Reporting by Leika Kihara and Takahiko Wada; Editing by Chang-Ran Kim and Pravin Char)
By Leika Kihara and Takahiko Wada