51 Pages Posted:
Date Written: November 25, 2018
We construct a model for Bitcoin-like cryptocurrency as risky and costly bubbles in an infinite-horizon production economy with incomplete markets. This model is consistent with the following facts: i) the surging Bitcoin market presents enormous volatility, and ii) its price dynamics are significantly sensitive to both investor sentiment and policy stances, and iii) the Bitcoin market exhibits diverse cyclical features for US and China. Entrepreneurial firms choose to hold Bitcoins as liquid assets to buffer idiosyncratic investment distortions. The intrinsically worthless Bitcoins can emerge as rational bubbles only when market distortion is severe and public sentiment is optimistic enough. On the one hand, bubbly Bitcoins provide market liquidity to facilitate investment in the real sector, while on the other hand, they crowd out production through costly mining activities. Deterioration in market sentiment depresses Bitcoin prices but ambiguously affects aggregate output and investment. Moreover, our quantitative exercise is able to produce various cyclical features, as shown in the data. Finally, the collapse of Bitcoin bubbles is shown to improve social welfare by decreasing distortion-driven real investment.
Keywords: Bitcoin, Cryptocurrency, Liquidity Constraint, Stochastic Bubbles, Market Sentiment, Store of Value.
JEL Classification: D84, E30, E60, G10.
Suggested Citation: Suggested Citation