Currency Substitution under Transaction Costs

Abstract

A major selling point and feature of cryptocurrencies is that they allow anonymous payments around the globe without a third party watching. For payments of certain goods, this censorship resistance feature makes cryptocurrencies more suitable or less costly a medium of exchange than traditional fiat monies such as Dollars or Euros. On the other hand, there exist goods which are easier to acquire using traditional means of payments. The costs of employing cryptocurrencies may involve fees to miners, while traditional money might be subject to taxation. In this paper, we explore how asymmetry in transaction fees across goods drives currency substitution. We assume a continuum of differentiated goods which can be strictly ordered according to the costs agents occur when purchasing these goods with Bitcoins as opposed to Dollars. In a market equilibrium, agents endogenously decide which goods to acquire using Dollars and which goods to purchase using Bitcoins. The marginal good at which agents are indifferent between purchasing with Bitcoins or Dollars depends on and varies in the size of the value-added-tax and transaction fees to miners.

Keywords: currency substitution, cryptocurrencies, Bitcoin, transaction costs, value-added tax

JEL Classification: E41, E42, F31