A Monetarist View of Money and Bitcoin


I’m market monetarist leaning, so it’s not surprising that I mostly agree with Scott Sumner that bitcoins are not money, except for me there is a caveat: it’s not money yet, and at least not in its current form. I think, however, that crypto-currencies could become money under the right scenario. More on that later. The purpose of this post is to explain in detail why bitcoins are not money.

But first, what is money, exactly? As Sumner says, the ordinary conversational definition of money can be quite different from what economist call money, especially for market monetarists. For economists, what makes money money is how it relates to and effects the economy as a whole. We’ll get to that in a second.

To get straight to the point, we define money as the medium of account: it is the unit in which all prices in the economy are quoted. This is different than a medium of transaction, which can be anything used to facilitate exchange. For example, you might accept apples from me as payment. You might accept a foreign currency. You might also accept bitcoins. That would make apples, foreign currency and bitcoins each a medium of transaction. But if you live in America, you would only accept these payments after converting your original US dollar price. Your true price is measured in dollars because everything else you want to buy in the economy are also priced in dollars. In America, that makes dollars the medium of account  that makes dollars money.

Now, the medium of account is almost always also used as the medium of transaction (that is, I will almost always give you money and not something else), but don’t let that confuse the difference. And don’t be confused by the fact that different economies will have different money — for example, euros are money in Europe but not America, and dollars are money in America but not Europe. And then there’s the fact that both dollars and euros are used as a medium of transaction pretty much everywhere (most places in Europe will gladly accept dollars, after converting from the euro price of course). Notice that I can say a medium of transaction but will only say the medium of account. Anything can be a medium of transaction, but an economy has only one medium of account.

Let’s try to explore this further with a realistic bitcoin example. Suppose I am selling you something. When you ask me for the price, I will give you a quote in dollars. Dollars are money, after all, and money is my chief concern because everything else in the economy is quoted in money. If you request to pay me in bitcoins, I will simply you give an equivalent bitcoin price by converting my dollar price using the most current exchange rate. Once you send me your bitcoins, I will then immediately convert them into dollars so that I end up with the original dollar price I wanted in the first place (this is literally how it works at every website that says it accepts bitcoins as payment). If the exchange rate between dollars and bitcoins changes, the amount of bitcoins I will require from you will change as well, so that the price I quote you in bitcoins could literally fluctuate by the minute depending on the volatility of the exchange rate. The dollar price, however, will remain unchanged  economists call this phenomenon price stickiness. This is a key feature of money: Prices denoted in the medium of account tend to be sticky, while prices denoted in other units tend to fluctuate. Price stickiness is what makes the medium of account so important.

How exactly did dollars become the medium of account? Patience, we’ll get there.

From here on I will use the words “money” and “medium of account” and “unit of account” to mean the same thing — they are all interchangeable.

So what’s so special about money? Well as Sumner explains, money has a powerful influence over the economy. In particular:

· Changes in the supply/demand of money cause inflation/deflation.
· Changes in the supply/demand of money cause changes in interest rates.
· Changes in the supply/demand of money cause business cycles.

Changes in the supply or demand of bitcoins do none of these things and that alone means they are not deserving of the name “money”. The reason money has these effects is because of the price stickiness I described above and a similar phenomenon called money illusion. If you want to understand these effects, you should read Scott Sumner’s blog or read this paper. And since central banks control the supply of money, the decisions they make greatly impact the economy — we call decisions concerning the supply of money monetary policy. As an example, in Canada, the Bank of Canada has decided that it will control the supply of money in such a way so that medium-term inflation is 2% — and they have been very successful. The ability to conduct monetary policy is a crucial feature for Bitcoin or other crypto-currencies to have if they are ever to become money.

The question I would like to explore is: Under what scenario would bitcoins become money? And what would monetary policy look like if they did?

Understanding the difference between money and something that is simply a medium of transaction will be important to understanding why a central bank might adopt a crypto-currency like Bitcoin as money and how monetary policy would be conducted in such a world. Before that, we need to discuss how paper currencies originated, why central banks were created to regulate them and how they became to be money. That will be next — stay tuned.



This is Part 2 of a discussion on the economic consequences of Bitcoin. You can access the remaining parts here:

1.  A Friendly Introduction for Economists to the Bitcoin Protocol
2.  A Monetarist View of Money and Bitcoin
3.  A Brief History of Paper Currency and Central Banking

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