Cryptocurrency, Money Demand and the Mundell-Fleming Model of International Capital Mobility

Abstract

If cryptocurrencies are perceived as financial innovations that could disrupt domestic and international financial systems, it becomes imperative for economists to incorporate these virtual currencies into existing money market models. Cryptocurrencies, when fully adopted by the general public, would transmit into the financial system via money demand. Cryptocurrencies serve as money and non-money assets and have no perfect substitute, whereas they are perfect substitutes for M1. Therefore, how much impact would the popularity of cryptocurrencies have on domestic and international capital mobility? To isolate interest rate differentials across countries, the Mundell-Fleming model that assumes a constant interest rate in domestic and world economies was applied. Cryptocurrencies acquired in past periods that are acceptable worldwide would abrogate exchange rate differentials. This study theoretically finds that fiscal and monetary policies would have different impacts on income in economies with high cryptocurrency circulations compared to economies with only M1. Also, there is a critical interest rate where cryptocurrencies would be more attractive to investors than other non-money assets. Moreover, using the Keynesian aggregate income and aggregate expenditure model, without interest and exchange rate differentials, the worldwide use of cryptocurrencies in international trade would unveil the link between the twin deficits and international capital flows.