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Following questions are related to a crypto project I am working on and proper answers are of utmost importance to this concept's development. I unfortunately lack expert knowledge about money supply mechanisms and quantitative easing. What mostly affects possibility of cryptocurrencies becoming worldwide-accepted money, beyond technical issues, is their inherent instability to fiat currencies, which renders them useless for everyday common transactions - because their price fluctuates so much (mostly because of speculation) and nobody trusts fluctuating unit-of-exchange.

So, in a fiat world when the buying power of money is decreasing, central bank expands money supply by simply printing more money (or rather they "create money" in exchange for government bonds as far as I know) and if the buying power of currency unit is increasing, central bank decreases money supply by selling bonds for money.

Now in cryptocurrency world similar approach recently resurfaced (just as an idea now, I don't know of any working implementation). It uses something like "seigniorage shares". Basic idea is we want 1 unit of cryptocurrency to be worth 1 USD. So the proposed solution in situation when we need to decrease the money supply (1 unit of cryptocurrency is worth more than 1 USD) then the system, working like central bank will create out of nothing some seignorage shares and sell them for investors hoping the system will buy them back in future for more cash, with profit for investor. Reversing this, if system needs to increase money supply (1 unit of cryptocurrency is worth less than 1 USD) it will buy those seignorage shares from users in exchange for units of that particular cryptocurrency. So far, it works like central bank.

But in cryptocurrency world, in theory, there exists another, more straightforward approach. We could just measure the price of 1 unit of cryptocurrency in comparison to USD and increase or decrease money supply by just simply increasing or decreasing balances of cryptocurrency's account-owners pro-rata. So basically, if we need to put 10% of total cryptocurrency units out of existence to regain peg 1Crypto: 1USD, we could shrink all account balances by 10%, simply. And if we need more units in circulation to regain peg, then we increase all account balances pro-rata. It seems like it would work and it would work like central bank.

But bank uses shares as an instrument to take money and give money. One of the cryptocurrency experts Robert Sams wrote in his paper (https://bravenewcoin.com/assets/Whitepapers/A-Note-on-Cryptocurrency-Stabilisation-Seigniorage-Shares.pdf):

"How not to distribute One simple solution is to distribute pro-rata over all coin balances. This is the approach advocated by Ametrano in his creative coin stabilisation scheme dubbed ”Hayek Money”. This approach has the virtue of simplicity. All wallet balances are simply multiplied by Qi/Qi−1 in each period to arrive at a new wallet balance. [...] The problem is that this scheme only stabilises coin price, it doesn’t stabilise the purchasing power of a wallet balance. Recall the three functions of money: 1. Unit-of-Account 2. Store-of-Value 3. Medium-of-Exchange Price stability is not only about stabilising the unit-of-account, but also stabilising money’s store-of-value. Hayek money is designed to address the former, not the latter. It merely trades a fixed wallet balance with fluctuating coin price for a fixed coin price with fluctuating wallet balance. The net effect is that the purchasing power of a Hayek Money wallet is just as volatile as a Bitcoin wallet balance."

My questions: Why is that? Why more brutal method - increasing or decreasing account balances pro-rata wouldn't work in light of R. Sam's argument? Why he says that purchasing power of such wallets (accounts) would be just as volatile as in pre-determined non-flexible money supply systems, like Bitcoin? Why we need shares as a catalyst, why we need them at all?

Or, maybe, we don't and increasing and decreasing accounts pro-rata is same effective?

Thanks for help.

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    $\begingroup$ One problem with this question is that you are making an assertion that in the real world, central banks manage monetary policy using the quantity theory of money. This is perhaps a controversial topic, but I am unaware of any current central bankers that believe the quantity theory of money. It would help if you edited out that part of the question, and just focus on the crypto currency part. $\endgroup$ – Brian Romanchuk Jun 26 '18 at 1:54
  • $\begingroup$ So, I didn't said the banks manage monetary policy using the quantity theory of money, I said they manage inflation by increasing or decreasing money supply. It does so using bonds as a tool. My questions are clear - there is an assumption of R.Sam (cited) that in cryptocurrency reality we need similar bonds called "seignarage shares" because simply increasing or shrinking balances in cryptocurrency accounts will not work to stabilize coin for example against dollar. But why? Why some kind of shares/bonds are needed? It's clear, it's just difficult question. $\endgroup$ – user84415 Jun 26 '18 at 6:28
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    $\begingroup$ Central banks can change interest rates without doing any operations that affect the monetary base. They can just announce a change to the policy rate, and it will be transmitted to the banking system via borrowing/lending settlement balances. You should eliminate your discussion of what you think central banks do, rather just ask: how can a body set interest rates for a crypto currency, and will the effect be? $\endgroup$ – Brian Romanchuk Jun 26 '18 at 10:25
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As I noted in a comment, the description in this question of real world central banks is overly simplistic. Central banks do not make proportional changes to the monetary base to set the price level. However, I will ignore those problems, and just address the core of the question:

1) Will it make sense to change account balances on a pro rata basis to keep the price of a crypto currency stable? 2) Will “seigniorage shares” work to stabilise the currency value?

I will cover each of these in turn.

1) Pro-rata change policy would have no benefits for holders of the currency. Imagine that the currency lost 10% of its value in trading one day, and so holders have a loss of purchasing power. If balances are reduced by (approximately) 10% to balance this, even if the currency returns to parity, you still lost 10% of the value of your holdings, since you have 10% less units.

This would also make any contractual obligations extremely awkward: any contract involving future payment would have to take into account the change of base. All transfers would have to effectively cease before the redenomination of accounts, in order to inconsistencies. If contracts do not take into account the change of base, you have no idea whether you can meet a future obligation. If I have \$100 in a bank account, I know that I can make a payment of \$90 next week, and could plan around that. If account balances are changing in an arbitrary fashion based on the exchange rate, I can no longer plan ahead.

If the overall “market capitalisation” of the currency had a tendency to be stable, pro-rata changes might keep the value of the unit stable. But of the “market cap” is changing, the value of the unit would still change, but not as much. However, this is just cosmetic, like a stock split.

2) I will admit that I have not read the linked paper on seigniorage shares, but I doubt that any such scheme could work, based on the description provided. The description given here states that developers create a “central bank” that issues the equivalent of Treasury bills to create an interest rate in the crypto-currency in order act like a real world central bank using interest rate policy. The problem is that real world central banks make seigniorage profits by buying Treasury bills issued by the fiscal arm of the government (the Treasury), and the Treasury is paying the interest. The Treasury can do this because it receives tax revenue, future tax revenue backs the interest stream.

The crypto central bank has no tax revenue. It can only pay interest by “printing” more currency units. The more interest is pays, the greater the future dilution of the crypto-currency. This does nothing to make outsiders believe that the crypto-currency will be more valuable in the future.

The only way such a scheme could help stabilise the value of the crypto-currency is that the “central bank” was engaging in activities that were in some sense profitable, so that those “profits” would cancel out the dilution that results from interest payments. For example, it could levy a small “network fee” on transactions (which is the sort of tax I believe that crypto-currency backers want to avoid). However, it is safe to say (based on equity market price volatility) that profit expectations are hardly stable, and so the value of the crypto-currency would change as “profit” expectations change. Since raising the rate of interest paid by the central bank will not improve its expected profitability, it would not be in the analgous position of a real world central bank, which is increasingly profitable as it raises interest rates. As a result, there is no reason for a crypto interest rate policy to act like real world interest rate policy.

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  • $\begingroup$ So, basically the stable cryptocurrency is "the holy grail" of cryptocurrencies, because their inherently speculative character makes them unusable for exchanging value. Unfortunately, many blockchain developers have good understanding of technology, but not so good of economics. I don't know how central banks operate currencies so they are more or less stable, but I want a cryptocurrency that would be stable (stable compared to dollar or some price index or some basket of goods). Now, many people are coming with a solution that we should algorithmically reduce or increase money supply. $\endgroup$ – user84415 Jun 26 '18 at 14:38
  • $\begingroup$ Those who favour this solution say that reducing or increasing money supply symmetrically with fluctuations of price of cryptocurrency will make it stable in the long run. So putting aside how we will do this, will this solve the problem? If I will add and remove units of cryptocurrency from totality of theirs in amount corresponding to ups and downs in pricing of 1 unit, will it stabilise currency in the long run or not? $\endgroup$ – user84415 Jun 26 '18 at 14:42
  • $\begingroup$ Furthermore, as far as I understood your answer, shrinking and increasing account balances pro-rata actually WOULD stabilise parity with some fiat currency or commodity (chosen for recalculation)? The only problem is practicality of this solution - because nobody would know how much units they will have in the next recalculation. But it would solve the problem of parity just as good as "seignoirage shares" mentioned in the cited paper by R. Sam or not? $\endgroup$ – user84415 Jun 26 '18 at 14:46
  • $\begingroup$ Because the goal is to make cryptocurrency stable in relation to some external commodity or fiat, so even in contractual agreements it could easily be said that one party has to pay another party this-and-this amount of dollars, denominated in cryptocurrency at the time and rate of exchange in the moment of paying. The whole idea is to make digital money which are deterring to speculators (because it's price constantly returns to parity with something) and good for unit-of-exchange and store-of-value. As I see you have some knowledge, I kindly ask you for your thoughts on the subject. Thank yo $\endgroup$ – user84415 Jun 26 '18 at 14:50
  • $\begingroup$ @user84415 I will try to expand my answer to try to cover at least some of these points you raised. Cannot do so immediately. However, trying to stabilise the value of a currency unit is tricky, and it is hard to make statements that are not purely opinion-based. $\endgroup$ – Brian Romanchuk Jun 26 '18 at 15:36

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