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Digital Currency and Its Impact on Monetary Policy

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Since the catastrophic global financial crisis, which was directly caused by the burst of the housing bubble and mortgage default, in 2008, the Federal Reserve alone has injected roughly 7.6 trillion dollars into the global economy by the end of 2019 in order to facilitate the recovering of the economy and mitigate recessions. An alternative asset which is called digital currency or cryptocurrency emerged in 2009 due to the rising distrust of central banks and the worries over inflation. The first and the most influential digital currency developed by Satoshi Nakamoto is called Bitcoin. Featuring decentralization, distributed ledger and fixed eventual total supply, this new type of currency has got a lot of interest over the past decade. Recently, discussions about an evolved version of digital currency, Central Bank Digital Currency, is in full swing. Economists and policymakers all over the world are exchanging ideas and insights on how to bring digital currency, especially Central Bank Digital Currency, onto the next stage.

In this paper, I first introduce digital currency and monetary policy briefly. Then I mainly focus on expressing my insights on what impact digital currency could potentially have on monetary policy. In these sections, I divide digital currency into two categories: private-sector issued digital currency and Central Bank Digital Currency (CBDC). By looking at the present wide-scale global economy and current protocols of digital currencies (mainly, Bitcoin), I come to conclude that digital currency is very unlikely to affect monetary policies. Even the impact of central bank digital currencies on monetary policy and macroeconomics is neutral.

The Emergence of Bitcoin is Inevitable

The concept ‘digital currency’ is somewhat ambiguous since, generally speaking, digital currency is any type of currency that is available in digital form. The term ‘digital currency’, however, I refer to in this paper most of the time has a specific name called virtual currency. To be clearer, digital currency, in its broad sense, is any currency in digital form such as debit cards, e-currency. In its narrow sense, digital currency is a virtual currency, or so-called cryptocurrency, that is created based on the distributed ledger technology and encryption technique (Xinxiang Weng).

In January 2009, a Japanese who is pseudonymous as Satoshi Nakamoto published the white paper titled ‘A Peer-to-Peer Electronic Cash System’ which is the protocol of Bitcoin. Bitcoin, the most prominent digital currency at present, along with other descendants, have features that differ them from traditional currency such as private-sectors issued, internet-based, no central clearinghouses and intermediaries needed, total supply fixed by its current protocol, according to the Quarterly Bulletin, Bank of England (2014, Q3). Learning from the timing when Bitcoin was created, it is a byproduct of the 2008 financial crisis. In 2008, the plummet of real estate prices triggered the burst of the housing bubble and credit crush which caused panic and runs on banks, which consequently dragged the whole financial system into extreme liquidity shortage. In order to save the global financial system and prevent further recession, just the Federal Reserve itself has increased M1 money stock by 2.6 trillion dollars and M2 money stock by 7.5 trillion dollars by October 2019, not to mention other major central banks in the world such as Bank of Japan. Although the inflation rate in the U.S is still kept around 2% over the decade, worries over inflation and distrust on central banks bred the innovation of Bitcoin and other digital currencies because: 1) the protocol ensures the supply of these currencies is not controlled by any central bank (as known as decentralization) by the application of distributed ledger technology (DLT); 2) the supply is fixed; 3) encryption technique enhances privacy and security.

Decentralization is the ultimate goal chased by many people with free-market psychology. The fixed eventual supply ensures digital currencies relatively deflate over time. Under the premise of maturity of technology, disappointment and the desperate need for financial stability makes the innovation of digital currency almost inevitable. However, there is a lack of appropriate regulation and insufficient oversight. This causes the digital currency market chaos and has attracted the attention of governments.

Central Banks Tend to Issue Their Own Digital Currencies (CBDC)

With the impact of the rapid development of decentralized digital currencies such as bitcoin on the monetary policies of various countries, central banks in major countries recognize that even if they strengthen the supervision of private digital currencies through legislation, they can only protect users’ rights and prevent various types of criminal activities; but they cannot prevent the central bank’s monetary policy from being adversely affected by it. Therefore, while certain encrypted digital currencies represented by bitcoin have been tested by the market for their necessity, feasibility, and security, the central banks of some countries are taking action on exploring the possibilities of issuing their own CBDC.

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Bank of England has been theoretically exploring the possible impact of CBDC on the overall economy since 2016. Economists from Bank of England suggest central banks issue their own digital currency, claiming that “…it (CBDC regime) leads to an increase in the steady-state level of GDP of almost 3%…” (Barrdear and Kumhof, 2019).

The People’s Bank of China has launched the CBDC prototype system, and the Digital Currency Institute belonging to the Central Bank has also been formally established in December 2016.

Monetary Policy

Every modern economy has its own monetary and fiscal policy. They both contribute to a sovereign state on influencing its economy. However, they take different paths. The monetary policy mainly controls the interest rate and money supply, whereas, the fiscal policy mainly controls government spendings and tax rates. In the United States, the Federal Reserve conducts monetary policy. “To promote maximum employment, stable prices, and moderate long-term interest rates – the three economic goals…by managing the level of short-term interest rates and influencing the overall availability and cost of credit in the economy. …Influences household spending, business investment, production, employment, and inflation in the United States” (federalreserve.org). In short, the Federal Reserve uses conventional and unconventional monetary tools to achieve both macroeconomic stability and financial stability.

Digital Currency is Unlikely to Affect Monetary Policy in Short Term

Most existing digital currency is not a currency issued by the central bank or public authority, and the circulation does not pass through the traditional commercial banking system. If it reaches a certain scale, the regulation and control of the central bank will be adversely influenced. The first is to weaken the effectiveness of the monetary policy. The prerequisite for the central bank’s regulation is the monopoly currency issuance right and the lender of last resort. By putting in or recovering the base currency, it regulates the liquidity of the banking system, affects short-term interest rates, and thus affects economic behavior such as savings and investment. When the digital currency reaches a certain size and functions as a currency in the economy, its quantity and price will have a significant impact on the real economy, and the central bank lacks the ability to regulate the quantity and price of these currencies. The second is to affect the revenue of seigniorage. The issuance and circulation of digital currency will weaken the central bank’s monopoly on currency issuance, causing the central bank to lose seigniorage. The third is to reduce the accuracy of monetary indicators. Some digital currency payment networks may be an alternative to the existing payment system with central banks and commercial banks as the main body, and since the circulation of these currencies does not pass central banks, it will undermine the central bank’s ability to monitor fund flows and collect information through the existing payment system. Less sensitive to market information will, in turn, weaken central banks’ ability to conduct effective monetary policy.

In contrast to private-sector digital currencies, CBDC will have a positive impact on monetary policy if it is interest-bearing. It will create a new price-based monetary policy tool. The first is to help enhance the transmission of central bank policy interest rates to medium and long-term credit interest rates. The second is to help lower the interest rate. The current lowest limit of the nominal interest rate is zero. If the central bank digital currency is issued at the retail end and the use of large amounts of cash is abolished at the same time, a negative interest rate may be calculated on the central bank digital currency, or just simply charge a wallet storage fee on the central bank digital currency. According to authorities from the National Bureau of Economic Research, “Interest-bearing CBDC mitigating the need to deploy alternative monetary tools such as quantitative easing or to rely on fiscal interventions in order to restore price stability…With interest-bearing CBDC, there would no longer be a compelling need to maintain any inflation buffer” (Bordo and Levin, 2017).

However, neither private-sector digital currency nor CBDC is likely to affect current monetary policies in short term since the scale of digital currency (mainly Bitcoin) is limited and accounts for a tiny portion, which is roughly 0.23%, of the total amount of broadly defined money in the world (Raul, 2018).

Conclusion

Digital currency is an inevitable byproduct of the 2008 financial crisis. It has advantages as well as disadvantages. However, the existing digital currency regimes cannot make huge waves in the global market because of their limited sizes. They only fulfill the roles of money for a tiny portion of people. Some practical examples such as Venezuelans use Bitcoin to protect their individual financial stability against the hyperinflation happens in their country. Another form of digital currency, Central Bank Digital Currency, will only have a positive impact on monetary policy in the future since Central Bank Digital Currency is issued by central banks, they will deliberately scheme and regulate its usage in order to retain control over the monetary system and ensure not to harm vested interest groups. Most governments will not allow any digital currency system, even CBDC, to substitute the traditional fiscal money system in short term. There is still a long way towards a decentralized currency system.

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Digital Currency and Its Impact on Monetary Policy. (2022, October 28). Edubirdie. Retrieved February 3, 2023, from https://edubirdie.com/examples/digital-currency-and-its-impact-on-monetary-policy/
“Digital Currency and Its Impact on Monetary Policy.” Edubirdie, 28 Oct. 2022, edubirdie.com/examples/digital-currency-and-its-impact-on-monetary-policy/
Digital Currency and Its Impact on Monetary Policy. [online]. Available at: <https://edubirdie.com/examples/digital-currency-and-its-impact-on-monetary-policy/> [Accessed 3 Feb. 2023].
Digital Currency and Its Impact on Monetary Policy [Internet]. Edubirdie. 2022 Oct 28 [cited 2023 Feb 3]. Available from: https://edubirdie.com/examples/digital-currency-and-its-impact-on-monetary-policy/
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