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The following question is based on a hypothetical scenario, in which the goal(s) is/are to identify how system participants may use/abuse the system to their benefit.


You are in the fortunate position to be able to create your own currency, which we will call Galatic Dollar (or GD), which is not tied to any economy or country.

You will act as the "central bank" for your currency by maintaining money supply. You will do this through a set of tools:

  1. Maintaining/Owning at least 99.5% of the money supply
  2. Using a fixed exchange-rate policy by pegging your currency against a basket of other currencies at their lowest denomination

For simplicity sake, there are only 3 foreign exchange providers and >90% of exchanges happen on these providers.

You thus decide to peg your currency against a basket of: USD, EUR and CNY (at their lowest denomination would be 0.01 CNY)

For another simplicity sake, we will assume that the GD (Galatic Dollar) is not a currency with supply in the trillions. Based on this assumption, we (the "central bank") will allow fluctuations of between 0.01-0.05 for normal exchange to flow.

Your mandate is to ensure that the GD meets the standard definition of money: medium of exchange, a unit of accounting, and a store of value.

Scenarios where monetary policy is applied:

  • Currency pumping : some actors on an exchange decide to create volatility by buying up lots of GD - the "central bank" steps in and quells this by playing market-maker and selling its supplies

  • Decrease in confidence : some actors decide to spread rumours in order to enable a shorting of the GD - the "central bank" periodically applies measures where money supply from its reserves are destroyed AND by maintaining the peg at the lowest denomination (CNY 0.01), the GD cannot be shorted into oblivion

  • Arbitrage - the "central bank", as market-maker, ensures no price-arbitrage across the 3 exchanges

  • Maintaining supply - the "central bank" will occasionally create new currency to maintain its 99.5% supply


Question/s:

  1. How can participants in this model use/abuse the system to profit off of it?

  2. What fundamental flaws exist in this model?

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  • $\begingroup$ This question is big, and may need to have some parts cut out to make it manageable. One technical problem: “money” is a liability of the central bank, so it cannot “hold 99.5% of the money supply.” That might make sense for commodity money or a cryptocurrency, but is meaningless for something like a fiat currency or a commodity currency with less than 100% backing. $\endgroup$ – Brian Romanchuk Dec 22 '17 at 13:57

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