Question

Write 3-4 paragraphs that explain the following:

• What are digital or crypto-currencies? Why did they come about?
• How do they work specifically?
• Who uses them?

Write 3-4 paragraphs that explain the following about digital currencies with respect to currencies issued by national governments:

• How do they affect existing currencies from a monetary policy perspective of nations?
• How do they change the demand curve for existing currencies?

Answer 1

• What are digital or crypto-currencies? Why did they come about?
• How do they work specifically?
• Who uses them?

A cryptocurrency is a digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology—a distributed ledger enforced by a disparate network of computers. A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.

Understanding Cryptocurrencies

Cryptocurrencies are systems that allow for the secure payments online which are denominated in terms of virtual "tokens," which are represented by ledger entries internal to the system. "Crypto" refers to the various encryption algorithms and cryptographic techniques that safeguard these entries, such as elliptical curve encryption, public-private key pairs, and hashing functions.

Types of Cryptocurrency

The first blockchain-based cryptocurrency was Bitcoin, which still remains the most popular and most valuable. Today, there are thousands of alternate cryptocurrencies with various functions and specifications. Some of these are clones or forks of Bitcoin, while others are new currencies that were built from scratch.

Bitcoin was launched in 2009 by an individual or group known by the pseudonym "Satoshi Nakamoto." As of Nov. 2019, there were over 18 million bitcoins in circulation with a total market value of around $146 billion.

Some of the competing cryptocurrencies spawned by Bitcoin’s success, known as "altcoins," include Litecoin, Peercoin, and Namecoin, as well as Ethereum, Cardano, and EOS. Today, the aggregate value of all the cryptocurrencies in existence is around $214 billion—Bitcoin currently represents more than 68% of the total value.

Special Considerations

Central to the appeal and functionality of Bitcoin and other cryptocurrencies is blockchain technology, which is used to keep an online ledger of all the transactions that have ever been conducted, thus providing a data structure for this ledger that is quite secure and is shared and agreed upon by the entire network of individual node, or computer maintaining a copy of the ledger. Every new block generated must be verified by each node before being confirmed, making it almost impossible to forge transaction histories.

Many experts see blockchain technology as having serious potential for uses like online voting and crowdfunding, and major financial institutions such as JPMorgan Chase (JPM) see the potential to lower transaction costs by streamlining payment processing. However, because cryptocurrencies are virtual and are not stored on a central database, a digital cryptocurrency balance can be wiped out by the loss or destruction of a hard drive if a backup copy of the private key does not exist. At the same time, there is no central authority, government, or corporation that has access to your funds or your personal information.

Advantages and Disadvantages of Cryptocurrency

Advantages

Cryptocurrencies hold the promise of making it easier to transfer funds directly between two parties, without the need for a trusted third party like a bank or credit card company. These transfers are instead secured by the use of public keys and private keys and different forms of incentive systems, like Proof of Work or Proof of Stake.

In modern cryptocurrency systems, a user's "wallet," or account address, has a public key, while the private key is known only to the owner and is used to sign transactions. Fund transfers are completed with minimal processing fees, allowing users to avoid the steep fees charged by banks and financial institutions for wire transfers.

Disadvantages

The semi-anonymous nature of cryptocurrency transactions makes them well-suited for a host of illegal activities, such as money laundering and tax evasion. However, cryptocurrency advocates often highly value their anonymity, citing benefits of privacy like protection for whistleblowers or activists living under repressive governments. Some cryptocurrencies are more private than others.

Bitcoin, for instance, is a relatively poor choice for conducting illegal business online, since the forensic analysis of the Bitcoin blockchain has helped authorities to arrest and prosecute criminals. More privacy-oriented coins do exist, however, such as Dash, Monero, or ZCash, which are far more difficult to trace.

Criticism of Cryptocurrency

Since market prices for cryptocurrencies are based on supply and demand, the rate at which a cryptocurrency can be exchanged for another currency can fluctuate widely, since the design of many cryptocurrencies ensures a high degree of scarcity.

Bitcoin has experienced some rapid surges and collapses in value, climbing as high as $19,000 per Bitcoin in Dec. of 2017 before dropping to around $7,000 in the following months. Cryptocurrencies are thus considered by some economists to be a short-lived fad or speculative bubble.

There is concern that cryptocurrencies like Bitcoin are not rooted in any material goods. Some research, however, has identified that the cost of producing a Bitcoin, which requires an increasingly large amount of energy, is directly related to its market price.

Cryptocurrency blockchains are highly secure, but other aspects of a cryptocurrency ecosystem, including exchanges and wallets, are not immune to the threat of hacking. In Bitcoin's 10-year history, several online exchanges have been the subject of hacking and theft, sometimes with millions of dollars worth of "coins" stolen.

Nonetheless, many observers see potential advantages in cryptocurrencies, like the possibility of preserving value against inflation and facilitating exchange while being more easy to transport and divide than precious metals and existing outside the influence of central banks and governments.

Explain the following about digital currencies with respect to currencies issued by national governments:

• How do they affect existing currencies from a monetary policy perspective of nations?
• How do they change the demand curve for existing currencies?

Central banks tax and subsidize currency and or credit markets in order to influence purchase power retention, economic growth, consumption, investment and economic shocks. Think of monetary policies as a single payer insurance institution that will shield you from the harshest economic conditions. In principle. It’s costs? Taxes and deadweight losses to the economy.

Now, there is nothing wrong in principle with market interventions on behalf of the population, governments intervene in lots of markets. Problem is….

… most central banks err in their policies on the side of vested interest, on purpose (corruption) or accidental (calculation problem), actually precisely where you would expect monopsonist and monopolist to “err”. The track record of this insurance is… sketchy.

Now for contrast… trust in politicians and laws are really expensive, but trust in maths is cheap. Distributed P2P currencies are just that, currencies. Distributed p2p credit markets are just that… credit markets. No frills, no fancy stuff, no trust.

However, not all cryptos are the same.

With decentralized currencies like bitcoin there is no central issuer. So, interventions in currency and credit markets would need to go through explicit immediate taxation, explicit limits on holdings, explicit limits on credit lines.

Think sales taxes or sales subsidies, credit rationing adjusted every week or so to not loose immediacy.

If the decentralized crypto in question, like bitcoin, are also non-confiscatable and easily transferable, that kind of taxation is much harder to enforce. Currency will just leave the jurisdiction.

In short, monetary policies to smoothen out the economy runs into huge calculation and trusts problems. Policies are more expensive than you think and have huge deadweight losses. Distributed non-confiscatable crypto currencies render them practically useless.

As a practically costless medium of exchange, CBDC would enhance the efficiency of the payments system. For example, a recent IMF study pointed out that the introduction of CBDC would facilitate more rapid and secure settlement of cross-border financial transactions (He et al. 2017). CBDC would be particularly beneficial for low-income households, which tend to rely heavily on cash, and for small businesses, which incur high costs for handling cash or high interchange fees when they take payments using debit and credit cards. At a macroeconomic level, researchers at the Bank of England have estimated that the productivity gains from adopting CBDC would be similar to those of a substantial reduction in distortionary taxes (Barrdear and Kumhof 2016).

The interest-bearing design of CBDC, and the obsolescence of paper currency, would also contribute to greater macroeconomic stability, because interest rate adjustments would have the advantage of no longer being constrained by an effective lower bound in response to severe adverse shocks.

The merits of removing the zero lower bound have long been considered for existing currency systems, by Goodfriend (2000, 2016), Buiter (2009), Agarwal and Kimball (2015), and Pfister and Valla (2017) among others. The lower bound has been a key reason why many central banks currently aim at positive inflation rates of 2% or more, whereas CBDC will essentially eliminate the need to maintain this inflation buffer, or to deploy alternative monetary policy tools such as quantitative easing or credit subsidies.

Moreover, in the event of a severe economic downturn, CBDC would facilitate the provision of money-financed fiscal stimulus. Dyson and Hodgson (2017) point out that, in a downturn, funds could be deposited directly into the CBDC accounts of low-income households, cushioning their purchasing power from the effects of the downturn as well as from the temporarily negative level of the CBDC interest rate. Indeed, Friedman (1948) highlighted the complementarities between monetary and fiscal expansion under such circumstances.

CBDC is a natural extension of current trends in monetary operations. For example, most central banks already pay interest on the reserves of commercial banks, which are a large portion of the total monetary base. The Federal Reserve has expanded its capacity to pay interest to an even wider range of counterparties by borrowing funds in the US Treasury repo market. Moreover, the Federal Reserve Banks now maintain segregated deposit accounts for systemically important financial market utilities, so that the customers of those utilities know that their funds are secure, liquid, and interest-bearing. For example, segregated reserve accounts at the Federal Reserve Bank of Chicago have been created to hold the funds of customers of the Chicago Mercantile Exchange, and the initial margin accounts of customers of ICE Clear Credit.

Aiming monetary policy at true price stability would be substantively different from the current practice of inflation-forecast targeting. As noted above, most central banks have a 2% or higher inflation target, and place no weight on previous deviations of inflation from target, so that the aggregate price level follows a random walk with upward drift.

In contrast, under a price-level target, consumer prices would still exhibit transitory fluctuations, but monetary policy will ensure that the aggregate price level would return to its target over time. Households and businesses would be able to plan with confidence that the cost of a representative basket of consumer items (as measured in terms of CBDC) would be stable over the medium run and roughly constant at planning horizons of 5, 10, 20, and even 50 years into the future. This stability could be particularly beneficial for low-income households and small businesses, which typically have little or no access to sophisticated financial planning advice or complex financial instruments to insure against risks.

The widespread use of CBDC, and the obsolescence of paper currency, would discourage tax evasion, money laundering, and other illegal activities that are made easier by paper currency, especially, large-denomination bills (Rogoff 2016). This benefit is important in advanced economies, but even more pertinent for developing economies where a large fraction of economic activity is conducted using cash, and incidence of tax evasion is very high. The feasibility of CBDC has been demonstrated in Ecuador, where CBDC has become widely available through a simple and secure platform (a two-step verification with mobile phones and text messages).¹ Likewise, in Kenya’s government has been a pioneer in establishing a public-private partnership for providing low-cost digital payments through Safaricom, which currently provides digital payments (using the M-Pesa platform) to about 25 million Kenyan customers. Its two largest shareholders are
Vodafone (50%) and the Kenya Treasury Department (25%).

The risk of central bank passivity

Given the rapid pace of innovations in payments technology and the proliferation of virtual currencies such as bitcoin and ethereum, it might not be prudent for central banks to be passive in their approach to CBDC. If the central bank does not produce any form of digital currency, there is a risk that it loses monetary control, with greater potential for severe economic downturns. With this in mind, central banks are moving expeditiously when they consider the adoption of CBDC.