Monetary policy is concerned with a given country or financial system’s money supply. Policy makers seek to find the right balance of money circulating in the system versus growth rate in order to build a well functioning economy.

Conventional Monetary Policy

In conventional systems Central Banks, like the Bank of Canada (BoC), are the entities responsible for making these policy decisions.

The objective of the BoC, according to their website, is “to preserve the value of money by keeping inflation low, stable and predictable.” Their mentality is that low, stable, and predictable inflation will help Canadians make investment decisions with confidence, leading to long-term investments in the economy.

For instance, we expect the $20 CAD bill in our wallet to be able to buy roughly the same amount of goods next year as it does today. If the BoC decided to print a large amount of new bills overnight; the bills in our wallet would be less scarce, and thus less valuable.

In reality, the BoC affects monetary policy mostly through managing a benchmark interest rate, which affects the interest rates we receive or pay at chartered banks.

Digital Currency Monetary Policy

Digital currency monetary policy is established and administered in computer code, as opposed to by a group of people within a central bank.

The code is still written and decided by humans, so there are still policy decisions to make. What’s different, however, is that once a protocol (like Bitcoin) implements its policy, there’s no concern about if a policy will be followed because the algorithms follow policy automatically.

As is often the case with digital currencies versus their fiat counterparts, it comes down to trust and credibility. Credibility can be thought of as the difference between the central bank’s targeted inflation rate, and realized inflation rate; the greater the difference, the less credible.

Credibility notwithstanding, the pace and process of issuing the native currency are among the most important variables in determining its merit, and consequently, price.

Although there are multiple variables affecting a coin’s value, its scarcity and enforceable protection against future issuance are among the most crucial factors.

Bitcoin model

In January 2009, the first Bitcoin (BTC) came into existence. “Miners” receive Bitcoins as reward and compensation for lending their computing power to help validate transactions on the network.

Bestowing BTC as rewards is the only issuance mechanism that exists, so there’s no risk of “printing” more Bitcoin.

In the beginning, miners received a reward of 50 BTC per block they record, and this reward is cut in half roughly every 4 years (210,000 blocks). The current reward is 12.5 BTC per block, and will decrease to zero by the year 2140.

There are currently approximately 16.64 million BTC in the system, and the amount that will ever exist is fixed at 21,000,000.

Fixed consequences

While most currencies have potential inflation issues from governments printing too much money or altering the interest rate, Bitcoin’s monetary policy will lead to deflation since there is a fixed supply of how many BTC will ever exist.

If the “Bitcoin Economy” grows – the number of transactions in BTC grows, more merchants accept it, etc. – but the number of BTC is fixed, the relative amount of BTC circulating becomes more scarce.

At first glance, this is a desirable situation. When prices go down, you’d be able to buy more ‘stuff’ with your BTC. While fun in the short term, there are problems with this line of thinking.

Deflation could lead to hoarding of BTC as people see prices of goods and services decrease because they know their BTC will be worth more tomorrow than today.

With hoarding, the ‘true’ productive economy of trading goods and services suffers, or stalls, since many people would just sit on their BTC. This could cause a deflationary spiral, where prices approach zero over time and no one can get ahead financially.

However, a deflationary spiral may not take hold with Bitcoin, since network participants are already informed on the system parameters and adjust their expectations accordingly. With a fiat currency, deflation comes as a surprise, as it’s not the intent the central bank communicates to the market.

Staying in check

In pursuit of price stability, many central banks target a low, positive rate of inflation. Although both inflation and deflation cause potential dangers for a currency and economy, contemporary wisdom says deflation is the greater foe.

Whether digital currencies such as Bitcoin, with greater controls and communication, will prove able to operate effectively in a deflationary environment remains to be seen.

However, monetary policy is as much about instilling confidence in a currency’s users as it about establishing sound policies to begin with. In this regard, and to the extent that society trusts computers, an algorithm will not be as fickle as a board of governors.

An ancillary benefit may materialize simply by virtue of central banks facing competition from other viable currencies. Competition from a new breed of digital currencies could impose discipline and ensure central banks manage their fiat currency in responsible ways.

 

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