Bitcoin first entered the market in 2009. It has been gaining popularity ever since. Patel (2017) suggests that Bitcoin is a purely digital currency. “It’s decentralized, meaning there is no central authority that regulates a bitcoin’s worth or how many bitcoins exist” (Patel, 2017, para. 6). Furthermore, Bitcoin’s price is determined by the market only, which makes the currency as close to the perfectly competitive market as it can only get. The objective of this paper is to discuss the mechanics of money supply, functions of money, and whether Bitcoin can become a replacement for conventional currencies.
Money has three primary functions (Exploring Business, 2016).
First, it is a medium of exchange. People accept it in exchange for providing goods and services. To serve this purpose, it must be divisible, portable, durable, and difficult to counterfeit. If the above conditions are fulfilled, money becomes a universal medium of exchange that connects people from different occupations and countries.
Second, it is a measure of value. Money is a convenient and precise way of establishing the value and communicating it to the market.
Third, it serves as a store of value. People have confidence that money keeps its value over time. This function of money creates a foundation for financial markets and higher rates of economic growth.
Once the functions of money have been established, it is important to understand how it is regulated. Monetary policy refers to a set of tools that central banks can use to manage inflation and reduce unemployment (Amadeo, 2017). The U.S. Federal Reserve has an objective of maintaining an unemployment rate below 6.5 percent and keeping the core inflation rate between 2 percent and 2.5 percent (Amadeo, 2017). If these conditions are satisfied, the central bank can expect a healthy rate of economic growth between 2 percent and 3 percent increase in the economy’s gross domestic product (Amadeo, 2017. Central banks have several tools to conduct either expansionary or contractionary monetary policy. However, they are all closely related via commercial banks’ reserve ratio. The Federal Reserve has the following tools at its disposal (Amadeo, 2017).
First, the reserve requirement. The Federal Reserve obliges commercial banks to keep a certain share of deposits on reserve each night. If the Fed wants to conduct a contractionary monetary policy, it could raise the reserve requirement. On the other hand, if it needs an expansionary monetary policy, it would decrease the reserve requirement.
Second, the Fed funds rate. It is the interest rate that commercial banks charge each other for storing the excess cash overnight. This rate is transmitted by banks onto other interest rates, such as loan or mortgage fees.
Third, the discount rate. It is the interest that Fed charges banks for borrowing money from the regulator to ensure that they have a sufficient reserve ratio.
Fourth, open market operations. This tool changes the reserve amount of commercial banks without changing the reserve requirement.
Fifth, inflation targeting. It is a quite novel approach, which sets a clear expectation about future inflation.
In his publication, Paul Krugman (2013) suggests that Bitcoin serves only as the medium of exchange. He refers to Brad DeLong, who doesn’t believe that there is any real value underpinning the cryptocurrency. DeLong makes an argument by comparing the real value of Bitcoin to the underpinning value of both gold and the U.S. dollar. The economist suggests that gold has value in itself. On the other hand, the value of the U.S. dollar is confirmed by the U.S. government and the Federal Reserve. However, there is no reliable ceiling on the value of bitcoins and thus no reason to consider it anything but a medium of exchange as long as some people are willing to accept it.
I share the opinion of both Paul Krugman and Brad DeLong. While Bitcoin presents a compelling proximity to the ideal free market scenario, the cryptocurrency does not have any underpinning value. I am convinced that it has value only as long as some people believe in it. It is possible that Bitcoin will remain popular among certain groups of enthusiasts. However, I hardly doubt that it could replace major currencies. The U.S. dollar is reliable because it is backed up by the U.S. government, one of the greatest economies in the world. The U.S. dollar could become completely worthless only in case the U.S. government defaults, which is extremely unlikely in the foreseen future. On the other hand, tomorrow is not granted for bitcoins. It is possible that the currency will lose the major share of its value overnight due to some regulations or news. Furthermore, its supply is limited around 21 million (Krugman, 2013). Thus, instead of becoming a decent major currency, it is set to reward early adopters.
The overall impact of Bitcoin on the economy is uncertain, as there are both positive and negative aspects to it. It is a complex financial instrument that can be used to differentiate investors’ portfolios. In addition, it marks the enormous impact that technology has had on the global economy. While it is certain that some future form of digital currency could replace conventional money, I hardly doubt that bitcoins will fulfill this role. Goldstein and Kestenbaum (2011) suggest that privacy makes bitcoins popular for buying illegal products, such as drugs. It is dangerous as the cryptocurrency’s popularity among certain individuals can fuel the growth of the black market. Thus, I believe that, unless modified, Bitcoin is a threat to the economy much more than it is a benefit.
In conclusion, the objective of this paper is to discuss the mechanics of money supply, functions of money, and Bitcoin’s potential for becoming a major global currency. While this invention is an interesting way to differentiate one’s portfolio, it will never become an acceptable type of currency due to its structural inefficiencies.
- Amadeo, K. (2017). What is Monetary Policy? The Balance. Retrieved 19 July 2017, from https://www.thebalance.com/what-is-monetary-policy-objectives-types-and-tools-3305867
- Exploring Business. (2016) (1st ed.). Minneapolis.
- Goldstein, J., & Kestenbaum, D. (2011). What Is Bitcoin? Retrieved 20 July 2017, from http://www.npr.org/sections/money/2011/08/24/138673630/what-is-bitcoin
- Krugman, P. (2013). Bitcoin Is Evil. The New York Times. Retrieved 20 July 2017, from https://krugman.blogs.nytimes.com/2013/12/28/bitcoin-is-evil/?_r=0
- Patel, D. (2017). How The Bitcoin Revolution Will Affect Entrepreneurs. Forbes. Retrieved 19 July 2017, from https://www.forbes.com/sites/deeppatel/2017/06/26/how-the-bitcoin-revolution-will-affect-entrepreneurs/#17b0683459cb