Context:
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Digital money in the form of cryptocurrencies is gaining widespread popularity as countries like El Salvador has adopted Bitcoin as a legal tender.
Are cryptocurrencies viable as a medium of exchange?
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Anything in excess supply is cheap. So whenever a central bank prints more and more currency, its value erodes over time.
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The global financial crisis of 2008 resulted in a similar unprecedented expansion of central bank balance sheets. This sparked fears of debasement of currency.
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To prevent a similar thing from happening to Bitcoin, the founders fixed its supply to a set number. One unintended side effect of this was that, like a usual currency, the supply of Bitcoin could not be modified as per demand. This often causes price volatility, i.e. huge upward or downward movement of price.
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This in turn means that Bitcoin or any other Cryptocurrency is not suitable as a medium of exchange.
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Instead, it is a speculative asset.
How do stable coins solve the problem of price volatility?
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To get around the issue of speculative nature, Stablecoins, like USDT (Tether), have been introduced, whose value is pegged to a fiat currency by maintaining equivalent reserves.
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By providing much greater price stability, these Stablecoins hope to serve as viable mediums of exchange, and have proliferated rapidly in recent years.
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Still, the risk to the monetary policy will depend on the degree of currency substitution.
What are the challenges if cryptocurrencies are adopted as medium of exchange?
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Impact on monetary policy:
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If a privately-issued cryptocurrency begins to compete with fiat currency, something similar to Dollarisation would happen. For instance: In various Latin American countries, as citizens lost faith in domestic currency, they began transacting more and more in Dollars. This rendered domestic monetary policy ineffective, because domestic central banks cannot set interest rates and inject liquidity in a foreign currency.
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Widespread adoption of privately issued digital currencies as a medium of exchange will have the same impact. The domestic monetary policy will not be able to respond to business cycle needs and external shocks.
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Mega tech companies may start running global e-commerce or social networking platforms, issuing their own digital currencies to their global customer base. These digital currencies will serve both as a unit of account and a medium of exchange on their platforms.
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Reorganisation of global economic activity into digital currency areas (DCAs) that run across national boundaries. These DCAs will be characterised by their own digital currency and unit of account issued by the network owner. The size of these DCAs might become larger than various national economies.
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Loss of seigniorage (profit made by a government by issuing currency) revenues to governments from the monopoly issuance of fiat currency
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Fiscal revenues can also be adversely impacted by the increased tax evasion opportunities that crypto-currencies can facilitate.
Impact on rupee:
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Capital account volatility: If cryptos begin to get mined inside the Indian territory, they will induce capital inflows. It can increase capital account volatility. And if these cross-border flows circumvent capital flow measures, they also increase capital account convertibility.