Fundamental Concepts of Monetary System
In any economy currency plays an important role. Apart from acting as a medium of exchange currencies help to measure values, acts as a store of value and a unit for standardizing values of material goods and services. Regular currency includes paper notes, coins and money issued by central bank of a nation. Currency is actually capture in form of circulating bank notes and coins within an economy. Government regulates the designing and operation of these currencies, which are subject to law within the boundary of a nation.
Money can be broadly categorized into Fiat money and Commodity money. In the monetary system, Fiat money is the currency that does not have any intrinsic value. However, it is established as money without any use value only because government values it and buyers and sellers agree on its value for transaction. Commodity money on the other hand is defined as one that is created from a good mostly precious metals like gold, silver and has a use other than an exchange medium. Such a good is called commodity and so it known as commodity money.
In the twenty first century, the rapid spread of internet has made business and industries increasingly digitalized. With a growing E-commerce market, a new digital currency has introduced and gained attention of investors in the economy. In transaction between two parties in the e-commerce market, banks play the role of an intermediary. However, in such transaction the possible transaction reversal might be troublesome to the sellers. To resolve this issue, the system of e-currency or e-payment has been designed. The new system is considered as much cheaper than traditional system of banking. This system is known as Bitcoin and digital form of currencies thus invented is called cryptocurrencies.
The rise of cryptocurrency and spread of digital currency makes this an attractive area of research. The essay aims to find to what extent cryptocurrencies can act as a regular currency. An intensive research has been conducted between these two form of currencies using economic concepts related to money market. Additionally, the associated benefits and risks of cryptocurrency to draw a clear conclusion.
Before making a comparative analysis it is important to understand the basic functioning of these two currencies and its implication in the money market.
Equilibrium in the money market is determined from the interaction of forces of money supply and money demand. The money demand explains the relationship between quantity of money that people willing to hold at a certain point of time and factors influencing this desired quantity. There are different purposes for holding money. Based on these purposes the money demand is classified in three categories- transaction demand, precautionary demand and speculative demand. Transaction demand is demand for money for making payment of any anticipated payment of goods and services. Precautionary demand for money is when people hold money for unanticipated emergency expenditure. In line with fluctuating prices of bonds the demand for bonds and hence, money demand also fluctuates. In times of rising bond price people increases their demand in expectation that it will increase further. This creates speculative demand for money. The two major determinants of money demand are income and interest rate. Income has a positive influence on money demand. With rise in income people willing to hold more money and vice versa. When bank raises interest rate then people find it more profitable to keep money in banks rather than keeping it at home. Following the inverse relation between money demand and interest rate the money demand curve is downward sloping.
Functioning of Money Market
Money supply is the quantity of money available in an economy at a certain point of time. For regular or institutional currency, the money supply is determined by the central banks and hence, the money supply is given as a vertical straight line.
The money supply and money demand together helps to determine interest rate. This is known as the ‘Theory of Liquidity Preference’. The central bank thus by changing money supply can control the interest rate.
Figure 1: Money market equilibrium
Crypto currency is an alternative medium of exchange and treated as subset of virtual currencies and alternative currencies. They are also termed as digital currency. The path-breaking feature of these currencies is the implantation of cryptography. Cryptography is a practice or technique that provides a security in communication in the presence of third party. Cryptography was developed in order to meet the need of secured communication while the Second World War.With the combined effect of mathematical and computer science theory, there has been evolution in this system that allowed it to be used as mode of secured communication and transaction of information and money online. The application of cryptography makes the conversion of information into a code, which cannot be hacked or cracked. This also helps in tracking purchase and transactions. The cryptocurrency market uses cryptography in order to secure transaction between parties. Since the issuance of these kinds of currencies lies outside the discretion and operation of central authority, it enjoys immunity from the interference and manipulation of the government. The inbuilt anonymity of this digital currency makes the nefarious transactions like evading taxes and laundering money well-suited. Reflection of public imagination was materialized and well-captured in Bitcoin currency.
A group operating with pseudonym Satoshi Nakamoto in 2009 first introduced e-currency. Within only 6 years that is by 2015, 14.6 million currencies were circulated having gross market value of $.3.6 billion. The successful existence and operation of bit coins boosted the appearance of various competitive crypto currencies like Namecoin, Litecoin PPcoin and so on. Starting from introduction of Bit coin in 2009, there has been numerous others currencies in the existence made of applying cryptography. In 2011 Litecoin and Namecoin were launched. Ripple, Dogecoin, Primecoin and Mastercoin came in to operation form the year 2013. Aurorarcoin has been launched very recently in 2014
Compared to physical existence of real currencies, crypto currencies follow electronic creation and storage so that they can be saved on websites and computers for further use. These currencies are helpful in purchase of virtual elements like internet services, hosting, and domain and so on beside the things that physical currency can purchase. These make crypto currencies appealing in the modern era of digitized market system.
Economic Concepts Related to Money Demand and Supply
The interaction of supply and demand is one of the key drivers of Bitcoin price. The demand for Bitcoin depends on is value as an exchange medium or by the value for future exchange. The Bitcoin stock in circulation determines the supply of Bitcoin. Suppose B represents the current stock of Bitcoin and PB is the exchange rate Bitcoin. The total Bitcoin money supply is then given by
Now suppose the Bitcoin demand in circulation is denoted as MD. Assuming that the demand depends on general price level, P, size of Bitcoin market, Y and Velocity of Bitcoin in circulation. The Bitcoin demand is then given as
The equilibrium price of Bitcoin is then determined as
The price of Bitcoin thus increases with expansion of Bitcoin economy and level of inflation while price decrease with an increase in velocity and stock of Bitcoin.
The four basic function of money include use of money as a medium of exchange, as a unit of measure, a standard of measure and a store of value.
Medium of exchange
Money is an acceptable medium of exchange for both parties of transaction. It therefore provides a more efficient medium for satisfying wants.
Unit of measure
Money act as a common denominator to measure the value of goods and services. All the goods and services are measured in terms of money. Money thus enables people to compare goods and services in terms of their relative price based on their relative values.
Standard of deferred payments
In addition to act as medium of current exchange, money also serves the purpose of future deferred payments. This actually forms the basis for credit transaction.
Store of value
People uses money as a suitable way to store wealth for future. Money thus acts as a store of value.
In order to behave like a regular currency, cryptocurrency need to satisfy the properties of a regular currency. The next section makes a comparative analysis of potential supply growth, credibility and stability between cryptocurrency and that of a regular currency.
In the list of well-documented cryptocurrencies, Bitcoin is the currency having the lowest projected supply growth in future. After passing the initial phase of high growth rate the supply growth of Bitcoin has now reached to the level of stable global currency reserve. By the early 2020’s the supply is projected to fall below that of gold reserve. The supply growth of Litecoin, came shortly after Bitcoin is not much above than the Bitcoin. However, the supply is expected to increase in future though in both currencies the growth rate is projected to fall below 1% by the late 2020’s. For Ethereum, the supply growth is expected to remain at a moderately high level without dropping below 5% until 2030.
Properties of a Regular Currency
Figure 2: Present and future growth of Bitcoin, Ether and Litecoin
When the supply growth of Bitcoin is compared with the growth rate other national currencies and gold, Bitcoin is found to experience a relatively short life of transition from a phase of high supply growth to its current rate similar to regular currency. The figure below represents growth of global currencies reserve and that of gold from the past 25years to future 25 years and compares it with the growth rate of Bitcoin supply. From this projection, the supply of Bitcoin in the coming 25 years will increase by 27% while for Gold it is 52%, for Yen it is 64% and for Swiss Franc, US dollar, Euro and British pound it is 269%, 372%, 386% and 530% respectively. If the current trend continues then Bitcoin might have appeal as a store of value.
Figure 3: Comparison between expected growth of cryptocurrency and that of national currency
The digital currencies will gain a monetary role like a regular currency only when it can assure the potential holders that there will be no unanticipated issuance of currency supply. In the cryptocurrency list, only Bitcoin has achieved a credible commitment in terms of announced issuance schedule. In contrast to other coins, for Bitcoin no free allocation is allowed to the creators. People have to obtain it either buying or mining it. Ethereum has not yet committed to a clear issuance schedule. It rather has a high degree of discretionary autonomy over the decision of supply growth. Litecoin involves more than fifty percent chance to attack or to collusion among miners and coders. Unlike regular currencies, cryptocurrencies do not receive any political or democratic oversight on its issuers and therefore lacks credibility.
Without presence of central bank to control the money supply, cryptocurrencies fail to offer stability. Because of highly volatile and unpredictable demand, the predicted supply does not match with predicted purchasing power. The values of cryptocurrencies since their introduction have revealed a highly volatile trend. The cryptocurrencies could become stable when it will be the only form of money used globally and no one will exchange it with other currencies. This in turn implies such currencies are unlikely to be used as a unit of account.
Elimination of Middleman:
Most impressive benefit of this currency is that it discards the options of intermediary component in transactions like expensive brokers, lawyers and so on. In transaction made through real currencies upon purchasing real properties these brokers and intermediaries play huge role to raise the prices that in turn raises the cost. Crypto currency can actually act as large property rights database, which further can be used in execution of two party transacting contracts in the automobile, real estate sector. These eliminate the cost of legal fees and brokerage charges.
Comparative Analysis of Potential Supply Growth, Credibility, and Stability
Huge amount of people even including the developing nations population are now part of service facility of mobile linked internet usage. This is widely used in financial transaction of various services bringing forth huge market accessibility option for crypto currency. The application such currency can be hugely accepted in the era of online purchase and business inclination. The good attributes about crypto currency transaction is that it does not require any transaction fee and overall it incurs lower cost. With increasing access to mobile phones and internet connections, the popularity of these currencies should increase.
Exchange rate risk is normal phenomenon in events like global business transactions, frequent travelling which demands transaction on regular basis. The exchange-taking place involves some fees for conversion. Sometime the exchange cab also becomes problematic event. The usage of crypto currency like Bitcoin as excludes such conversion fees or charges by eliminating the fact that conversion is needed anyhow. These are universally accepted currencies. This also saves the time for price determination in any transaction-taking place making the currencies more approachable in global financial and monetary transaction making them agile and free of complexities.
Away from third party involvement, money retention regarding all of the funds are done much easier compared to situation under real currency. In real currency systems, operations like banks, brokerage, high the services like PayPal take control of the accounts and funds of the individuals who are left on the terms and services of these systems. The suspension of account and loss of money are totally under the discretion of them subject to violations caused against their rules and laws. This can reduce funds for important transactions. Such problems are not encountered in the crypto currency system as the entire amount of money is retained and only individual have the ability to change the terms if required.
Global networks use Blockchain technology in order to manage jointly the database taking control of the Bitcoin transaction tracking. There is an individual network that manages the transaction of Bitcoins and it lies outside of the interference of central authority. This type of decentralized system ensures the operation of network on user-to-user basis. It leads to formation of mass collaboration
The virtual money is not bound by the interest rates, exchange rates, transaction or other charges in any nation under any transactions. This makes it universally accepted and ready to be used without single node of difficulties. It makes transactions easy, quick saving time and money. The greatest thing about such currencies are that it allows the user to be complete owner of it without losing a single bit of money in terms of fees and violation penalties with securing global transactions at higher speed. With the spread of the benefits and positive attributes of crypto currencies to the layman, the acceptance would be more and eventually that will change the global economic system.
Easy Transfer of value:
Crypto currencies make transfer of currencies easy without facing any problems regarding geographical boundaries. The concept of cross border transaction and transfer of values are done easily through this currency system.
Lack of regulation:
One of the biggest problems that come with using crypto currency system is the regulatory concern. It facilitates unlawful operations in terms of various illegal transaction taking place online. These transactions are denominated in Bitcoins and many other type of crypto currencies. Silk road as one of the dark web facilitates illegal drug purchases in Bitcoins in 2014. This virtual money is increasingly used for money laundering. The sources are hardly detectable as the funding are collected through clean middleman brokers. It makes the government to suffer in tracking and seizing the black operations allowing the criminals to operate easily.
Potent for Loss:
The data loss in this system can cause substantial financial losses. Earlier it was believed by the proponents of cryptocurrencies that with adequate securities digital currencies ca actually act as alternative to the physical cashes carried by people with higher risk inherently and make users deviate from using it. With application of source codes that can be cracked, authentication protocol that cannot be penetrated and hacking defenses, the storage of money in cloud or other physical storage of data become easier compared to carrying real currencies in purse. These benefits are observable only if the crypto currency users take proper precautions so that data loss can be avoided. Storing private data in cloud or other physical storage exposes the user to higher loss if the devices get stolen or destroyed anyhow. It will cause greater financial harm. Using single cloud service in storing data can cause loss if the server is destroyed physically or disconnected from internet.
Loss of a wallet:
Maximum of the crypto currency users store their currency in their computer locked in a wallet file. These fall victim of stealing by using malware or can be lost on crashing of hard disk.
Investment in projects of crypto currencies and block chains is new trend among these currency holders. This fundraising is called Initial Coin Offering.
Higher volatility in price:
Having fewer outstanding units, crypto currencies are concentrated within handful number of individuals including the people who create them and are closely associated with them. These few holders of the currency manipulate the supplies of it which leads to higher swinging in the value leading to volatility in the market.
Hacking payment gateway:
In spite of using authentic payment gateway with citing proper address money can be lost. Hackers with their knowledge of social engineering techniques can convince the host or provider that they are the real owners of the domain. This way they get access and start intercepting flow of cash.
Error in the users’ address:
This is one of the very common issue under crypto currency system that causes loss of money and wealth just because of putting wrong address of the recipients of the transferred cash.
No Refunds or Charge-backs facility:
The miners of crypto currency act as quasi-intermediaries in transactions but they lie outside of the responsibility for dispute-staking place between parties involved in transaction of such currencies. This attribute of arbitrator imposes violation over the decentralization impulses of the modern crypto currency design. There won’t be anyone to be approached for if individual gets cheated by such system of currency.
In the system of crypto currencies problem of scalability exists in a huge manner. The solution of the problem lies in pulling in more customers and users in too the system under such currencies. Improvement of the database, codebase and legal framework, the system can be improved. Irrespective of developed or developing nations, legalization of the currency is taking place. Conservative countries like Russia are also improving the situation by allowing the market to come out of the black and shadowy effect of crypto currency transactions. Switzerland and Singapore are two countries to be proactive on this matter quite a lot.
To bring changes in the protocol is seemed as one of the way to get rid of the deficiencies of the crypto currency system. However, the changes are not that easy to achieve as it takes up much longer time to materialize the changes and the procedures are complex as well. The persistence in communal effort can help in bringing the changes and allow the execution of the proper planning pertaining to changes. Volatility of prices is one of the common phenomenon that appears in the class of new assets. Changing price reflects the adaptability of technology over time which plays better role in securing the application cryptography in currency. Attracting and including more customers into eco system is biggest step toward solving the issues associated with the currency system.
After discussing the positive as well as negative side of the crypto currency the authenticity and usability of the currency is quite evident to us. It can certainly be stated that such virtual currencies have to go a long way in order to replace the physical currencies exiting in present time. The newly introduced digital currency carries wider acceptability and logical reasons to accept it. The amalgamation of technology and economies brings forth wondrous possibilities for the economy as a whole in any nation. However, with aid and assistance provided through up gradation of technology, the currencies can gain greater acceptance among aware people. Cryptocurrencies are technically able to fulfill function of money as a medium of exchange. These electronic currencies are fully operational from any device if connected to the internet. However, these are completely unsuitable to use as a unit of account because of its fluctuation in demand and inflexible supply. Only Bitcoin can be used as a store of value because of some degree of credibility and predictability.
As per the regulatory authorities and their concern, in recent times, full swing operation of the virtual currencies over fiat currencies is quite impossible due to various economic concerns. The study reveals how crypto currency can lead to substantial losses within an economy in numerous form ultimately affecting the growth and development of the system as a whole. Apart from having lot of problems tapped within it, crypto currencies provide some unattractive appeal to the people as a whole in form of lack of support and legal status. The system lying outside of the government regulation leads to lack of proper and formal framework to resolve the issues of people. These leads to higher possibility of customer grievances to camouflages and stay unnoticed or addressed. The platform exchanges under these currencies are not backed and protected by proper law and regulation. This leads to potential financial losses which make the currency very risky to be applied on by business entities.
From the discussion it is evident how important role currency plays in building upon the monetary system of an economy. It can take form of paper currency, coin, legal tender or the virtual currency. Crypto currency as one of the virtual and digitized money is earning greater importance in the modern economy based on online purchase and sales. While carrying physical currency and using them as mode of payment are found to become risky and subject to time consumption, the online payment or paying money in form of digital currencies on virtual platform is attracting the attention of people mostly who are aware of these up gradation in mobile and internet usage. Due to increasing pattern in online transaction the use of such currencies have gone up due to the security it provides. However, the analysis in this paper also revealed the dark side of such currency system operating outside government supervision and regulation. These insufficiencies and insecurities of crypto currency are making it less practical or less apt to be used in modern economic system replacing the existing currency including paper money an d coins. For crypto currency to behave like real currencies, it has to attract more customer base and improve technologically overtime in order to provide more security backed by regulation and legality. Moreover, internet networking usage as well as mobile handling should be spread among mass in order to make people inclined toward online transact. This further expands the market for crypto currencies and forces them to come up with better attributes.
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Fiat money: Paper money or coins of little or no intrinsic value in themselves and not convertible into gold or silver, but made legal tender by fiat (order) of the government.
Commodity money: A form of currency in which the value of the currency comes from the material of which it is made.
E-commerce: commercial transactions conducted electronically on the Internet.
e-currency: One of the types of e-money that can be used to buy things on the internet.
Money demand: The quantity of money demanded at a certain point of time.
Transaction demand: Quantity of money demanded for transaction purpose.
Precautionary demand: Demand for money balances to cover unforeseen contingencies.
Speculative demand: Money held to purchase bond in anticipation that prices will fall.
Theory of Liquidity Preference: The theory of interest rate determination based on supply and demand for liquidity.
Cryptography: The art of writing or solving codes.