WORKING PAPER: On the Coexistence of Cryptocurrency and Fiat Money
The rapid growth of cryptocurrencies like Bitcoin raises many questions for consumers, investors, and policymakers. In a new working paper, graduate student Zhixiu Yu seeks to shed some light on the dynamics that arise when cryptocurrency coexists with fiat money.
Since Bitcoin was introduced in 2008, the market for cryptocurrencies has evolved dramatically. In July 2020, Bitcoin prices exceeded $10,000, and the total market capitalization of over 5,000 cryptocurrencies reached $320 billion. In recent years, as the number of companies that accept Bitcoin as a form of payment for goods and services has grown to include AT&T, Whole Foods, KFC Canada, Expedia, Subway, PayPal, and Microsoft, cryptocurrency has become an increasingly accepted form of monetary transaction.
What is cryptocurrency?
Recently, a U.S. Federal Court declared that Bitcoin is a form of "money" under Washington D.C.'s Money Transmitters Act. Unlike most common forms of fiat currency such as dollars or euros, cryptocurrencies are not backed by a central bank or any government authorities. The supply rules of cryptocurrencies are predetermined by a computer algorithm. Cryptocurrency is costly to produce: miners (the term for issuers of cryptocurrency) can produce cryptocurrency using a technology that requires capital as an input, and the cost of producing cryptocurrency increases in both the input capital and the stock of cryptocurrency in the market. It is also important to understand the deflationary property of cryptocurrency. For example, when producing Bitcoin, there are costs associated with using the input capital such as computer power and electricity, and the Bitcoin mining rewards halve every 210,000 blocks. Thus, the cost of mining the same amount of Bitcoin gets more expensive as the amount of Bitcoin has been minted.
Can cryptocurrency coexist with fiat money?
The growing acceptance suggests cryptocurrency has the potential to disrupt the traditional monetary system, and this raises several questions: Can cryptocurrency serve as a medium of exchange? Can cryptocurrency coexist as a widely accepted medium of exchange with an asset that costs nothing to produce, such as fiat money? Under what conditions can cryptocurrency and fiat money both be used as media of exchange? In this working paper, Zhixiu Yu proposes a theoretical framework to address these issues.
Through her model, Yu shows how the competition with cryptocurrency restricts the government's ability to over-issue fiat money. As she summarizes, "The policy implication of my analysis is that, if the government tends to over-issue money, then banning cryptocurrency would worsen the welfare. But if the government can maintain sufficient low inflation and acceptability degree of cryptocurrency is small, then banning cryptocurrency would be welfare-enhancing."