Crypto assets rely on decentralised protocols to run their monetary policy, unlike traditional fiat currencies, which are controlled by central banks and governments. These logs may contain a range of tools to regulate the supply of crypto, including block rewards, mining difficulty changes, and issuance fees. For example, Bitcoin (BTC) has a fixed supply limit of 21 million coins. Over time, the rate at which new coins are introduced into the supply continuously decreases, eventually leading to a deflationary situation when the rate of new supply approaches zero. In contrast, certain crypto assets may employ alternative mechanisms to manage their monetary policy, such as Proof-of-Stake (PoS) consensus systems that use staking to encourage network activity and control crypto supply.
The value of a crypto is mainly influenced by the market forces of supply and demand. A crypto becomes more expensive when there are more buyers than sellers willing to accept your offers. However, the price will fall if there are more sellers of a crypto than buyers willing to buy it. Other factors that can affect the value of a crypto are its utility, security and acceptance. For example, a crypto that is widely accepted as a means of payment and has a clear use case is likely to be worth more than one that is not widely accepted. Additionally, crypto assets with strong security features and a history of reliability are often more valuable than those with lax security or a history of attacks and failures.
Here are some ways crypto assets could affect monetary policy
- Reduced control over the money supply – Due to the decentralised nature of crypto assets and the lack of a central control authority, standard monetary policy tools such as printing money or changing interest rates may not have the same effect on them as they do on fiat currencies. This could limit central banks’ power to influence the total amount of fiat money in circulation.
- New Data Sources– Large amounts of transactional data generated by crypto assets could be used to provide important insights into consumer behaviour and broader economic patterns. Central banks may need to figure out how to incorporate this data into the decision-making process.
- Increased Competition- Because crypto assets offer an alternative method of payment and store of value, they may become more competitive than traditional fiat currencies. This could put central banks under pressure to keep their currencies stable and valuable to stay competitive.
- Improved Financial Inclusion– Crypto assets have the potential to provide greater financial access and inclusion for individuals and businesses that may not have access to traditional banking services. As a result, monetary policy may change as central banks need to consider how a more diversified and decentralised financial system will behave.
The rules of the protocol dictate how new Bitcoins are created and distributed over time. Additionally, any proposed changes to the protocol must be approved by a majority of network users, making Bitcoin’s monetary policy subject to the consensus of its users. In particular, the issuance schedule built into the protocol serves as the basis for Bitcoin’s monetary policy.
New bitcoins are produced through a process called mining, in which users compete for rewards, including newly created BTC, by solving challenging math problems. The mining reward is automatically halved for every 210,000 blocks (roughly every four years), a process known as halving. This suggests that the rate of the new BTC generation will decrease over time, eventually leading to a maximum supply of 21 million. One of the main components of Bitcoin’s monetary policy is its constant supply, which aims to maintain scarcity and prevent inflation.
A classic monetary policy transmission mechanism involves the use of various instruments, such as Central banks changing interest rates to affect the money supply, the actions of financial institutions, and the behaviour of individuals. However, stablecoins can operate separately from these conventional dynamics and may not be directly affected by interest rate adjustments or other monetary policy tools. For example, stablecoins can be viewed as a haven, particularly in times of market volatility or economic unpredictability.
Stablecoins could experience a surge in popularity during these times, which could lessen the impact of traditional monetary policy tools like rate hikes. In addition, stablecoins could alter the demand for traditional fiat currencies and hamper the effectiveness of the monetary policy if they were widely adopted. However, to consider the economy-wide implications of stablecoins and incorporate them into their policy frameworks, central banks may need to develop new strategies.
Let’s continue with the example of privacy design choice and understand its impact on monetary policy in the following two scenarios.
Scenario 1: Incognito and Unfindable Transactions
It might be more difficult for central banks to develop specific monetary policy tools that rely on transaction data to monitor and control the money supply if a CBDC is created in a way that is completely anonymous and untraceable. For example, if a CBDC is fully private, it could be more difficult for central banks to detect and stop illegal activities such as money laundering and tax evasion, which could affect the stability of the financial system and the effectiveness of monetary policy. Using CBDCs to enforce policies like capital limits or negative interest rates can also make it more difficult for central banks to monitor and regulate them.
Capital limits are restrictions on the total amount of CBDC that an individual or entity can own. Capital restrictions can be used as a measure to discourage CBDC hoarding and encourage consumption, which will help the economy thrive. However, capital restrictions can also have unintended effects, such as an increase in demand for alternative assets or a change in the composition of the money supply. When the interest rate on deposits is negative, depositors have to pay the bank to keep their funds instead of earning interest. Banks refer to this as “negative interest rates” when a central bank uses a negative interest rate policy to encourage investment and spending during economic downturns.
A CBDC can also allow central banks to operate negative interest rate policies that encourage spending and discourage hoarding if they are to generate interest. However, negative interest rate policies can also have unintended consequences that could increase financial instability by reducing the incentive for savers to put their money in banks.
Scenario 2: Transparent and Traceable Transactions
On the other hand, if designed to be fully transparent and accountable, a CBDC could potentially provide central banks with useful information about consumer behaviour and economic patterns that could guide their policy-making processes. However, it could also raise privacy and surveillance concerns. Central banks must therefore carefully consider the trade-offs between these measures and ensure that CBDCs are designed to support economic growth and stability while minimizing the risk of a financial crisis.