Volatility and Welfare in a Crypto Economy

Abstract

Proof-of-Work (PoW) blockchains possess at least two undesirable characteristics: exceptional price volatility and welfare impairment. Exceptional price volatility arises because PoW implements a passive monetary policy that fails to modulate cryptocurrency demand shocks. Welfare impairment arises because PoW compensates those updating the blockchain through seigniorage while facilitating free-entry among them. This paper theoretically formalizes the aforementioned points and also examines an alternative blockchain protocol that induces low volatility and enhanced welfare. The alternative protocol generates low volatility via an active monetary policy that modulates cryptocurrency demand shocks and facilitates welfare gains by supporting cryptocurrency prices with blockchain updating expenses.