Monetary Policy in Cryptocurrency

This article talks about the coexistence of cryptocurrencies and the central bank, and it discusses various aspects of monetary policy related to digital assets.

· 5 min read
Monetary Policy in Cryptocurrency

In this Article:1. Coexistence of Cryptocurrency and Central Bank2. Risks faced by Central Bank from Emergence of Cryptocurrencies3. Deflationary and Inflationary Risk by cryptocurrencies4. Cryptocurrency as a Medium of Exchange 5. Central Bank’s Digital Currency6. Conclusion

Today Cryptocurrencies are not only limited to techno-savvy investors, but other investors and the common population are also showing their interest in these digital assets. Currently, cryptocurrencies are operating alongside the official national currencies of the countries. The current trade volume and velocity of crypto assets are small, and they do not pose a challenge to the official money as the unit of account and medium of exchange. Blockchain technology is improving rapidly and so is the popularity of cryptocurrencies. It is yet to be seen whether the coexistence of crypto assets and fiat money would entail any risks for the central bank monetary policies. Cryptocurrencies might one day serve as an alternative means of payment and as a unit of account, which could seriously undermine fiat currencies.

Coexistence of Cryptocurrency and Central Bank

The coexistence of cryptocurrency and central bank highly depends on the monetary policy followed by the central bank of a nation. For instance, if in an economy, the official currencies do not ensure price stability, the privately issued currencies in the form of cryptocurrencies can be widely used, and similarly, if the central bank credibly guarantees the real value of the money balances in the economy, then the cryptocurrency might lose its value. Central banks can also use effective monetary policies to prevent cryptocurrencies from being valued as a medium of exchange. But even in this case, central banks cannot prevent cryptocurrencies to be valued as purely speculative assets.

From another perspective, cryptocurrencies do not necessarily pose a threat to the central bank. The coexistence between them can have a positive impact by acting as a disciplinary device on the central banks. Central banks will have to carry out effective monetary policies to fend off potential competitive pressure from the crypto assets. Central banks of different nations can also learn from the properties and features of cryptocurrencies and their underlying technology to make their fiat currencies more attractive for the new rapidly expanding digital age.

Risks faced by Central Bank from Emergence of Cryptocurrencies

Despite the potential benefits that crypto-assets offer to an economy, it does pose certain risks to the central banks:

  • Substitution of Cash & Bank Deposits: Cryptocurrencies may risk the effectiveness of monetary policies by substituting economic agents such as cash and bank deposits. The greater the extent of this substitution, the lower the control over monetary conditions by the central bank.
  • Possible Fiscal Risk: The shrinking role of fiat money creates a possible fiscal risk for the economy as a whole. It may lead to a loss of revenue for the government, which could lead to higher distortionary taxes.
  • Speculative Assets: The use of cryptocurrencies as an investment asset poses a greater threat than the potential use of them as money. Cryptocurrencies as a speculative asset are highly prone to bubbles, the collapse of which can lead to wider financial instability in the economy. In such instances, the central bank faces the double risk of ensuring the stability of the financial institutions and ensuring the overall price stability in the real economy.

Deflationary and Inflationary Risk by cryptocurrencies

In fiat economics, the monopoly for issuing the new currency notes or coins is with the central bank of a particular nation. This makes almost most of the major fiat currencies inflationary in nature, as they do not tend to have limited supply. In the cryptocurrency world, a specific crypto asset can have either limited supply or unlimited supply. The vast majority of coins have a limited supply including the first and most popular cryptocurrency, Bitcoin. These crypto coins with limited supply face limited inflationary risk. However, these coins lack certain functions of a stable monetary regime such as protection against the risk of structural deflation, the ability to respond to temporary shocks, and their capacity to function as a lender of the last resort. Thus, a cryptocurrency with a limited supply poses a deflationary risk.

In the cryptocurrency ecosystem, there are certain crypto coins that have infinite or unlimited supplies. These coins have their own rules and restrictions for issuing new coins similar to that of a central bank. The most popular cryptocurrency with unlimited supply is Ethereum. However, Ethereum is only an infinite coin given an infinite amount of time as the developers have fixed the amount of Ethereum coins that can be issued per year. These coins have an inflationary risk.

Cryptocurrency as a Medium of Exchange

Although currently, cryptocurrency is highly volatile, it is expected that with improved technology their volatility is expected to go down. The valuation of cryptocurrencies, in the long run, can become more stable. Under such circumstances, cryptocurrencies as a medium of exchange can offer certain benefits to the people and the economy. Cryptocurrencies can facilitate long-distance transactions with ease and can offer greater anonymity. Crypto Assets do not require intermediaries to settle the transactions. It also makes cross-border transactions less cumbersome and less costly. The unit of transactions of crypto assets is more divisible. Therefore, it is highly plausible that a few cryptocurrencies will eventually be more widely accepted and will act as a medium of exchange and unit of account.

But on the flip side of the coin, if the central bank loses its power to define the unit of account for most economic activities to the crypto assets, the monetary policy of the central bank becomes irrelevant for the economy. This is evident from dollarization in some developing nations, where the domestic financial system of the country operates with a foreign currency. In such cases, the monetary policy of the domestic currency becomes disconnected from the local economy, and thus in the real sense, the central bank of the nation loses its power and becomes irrelevant.

Central Bank’s Digital Currency

In this digital world, central banks should also consider coming up with their own digital currency. This could help them to counter the monopoly power that strong private cryptocurrency houses possess. Digital currency also reduces transaction costs and enables long-distance transactions. From the perspective of the monetary policy, this interest-carrying digital currency can assist in transmitting the policy interest rate to the rest of the economy when there is a decline in the demand for reserves. While designing this digital currency, the central bank should consider various policy trade-offs. Largely, views on the balance of benefits and risks are likely to differ from country to country, depending on circumstances such as the degree of financial and technological development.

Conclusion

The new digital age offers central banks both opportunities and challenges with respect to setting their monetary policy, coexisting with the cryptocurrencies. There is a need for the central bank to maintain the public’s trust in the fiat currencies and at the same time monitor and stay in the digital and decentralized new age economy. The crypto ecosystem is simpler and with the correct monetary policy, they can be integrated with the economy quite effectively and efficiently.