Lecture 13 - Cryptocurrencies I
1. What is a Currency?
Currency
A commonly accepted means of payment within a group of individuals.
At its most fundamental level, a currency is not defined by its physical form or by government authority. Instead, it is defined by collective acceptance. A thing becomes a currency when individuals expect that others will accept it as payment, making it rational for them to accept it as well.
Formally, an object functions as a currency if accepting it is individually optimal given that others accept it. This means that currency emerges through mutual expectations and strategic behaviour, rather than purely through intrinsic characteristics.
From an economic perspective, money is therefore a social institution sustained by shared beliefs and coordination among agents.
Currency can be understood as a coordination equilibrium. Each agent accepts money because others accept money.
The value of money therefore depends on expectations about future acceptance, rather than necessarily on physical or intrinsic properties.
Key characteristics of currency
- Widely accepted as a medium of payment
- Facilitates exchange in decentralised markets
- Sustained by expectations of future acceptance
- May or may not have intrinsic value
If you know that everyone else accepts pounds in exchange for goods, refusing to accept pounds would leave you unable to trade. Accepting the currency is therefore the rational strategy.
2. Intrinsic Value vs Monetary Value
A crucial insight in monetary economics is that currencies do not require intrinsic value.
Historically, many currencies did possess intrinsic value because they were made of valuable commodities. Examples include:
- Salt
- Rice
- Cattle
- Gold or silver coins
These items were natural candidates for currency because individuals would accept them even if they were not widely used as money, due to their inherent usefulness or scarcity.
However, modern currencies do not operate this way.
Intrinsic value
The value an object has due to its own physical properties or usefulness.
Fiat currency
A currency that has no intrinsic value and derives value solely from collective acceptance.
The British pound, US dollar, and most modern currencies are fiat currencies. Their value comes entirely from the fact that people believe others will continue to accept them in exchange.
Fiat money is sustained by self-fulfilling expectations.
If everyone believes a currency will be accepted tomorrow, it will have value today.
If those beliefs collapse, the currency loses value immediately.
3. Currency as a Coordination Device
A useful way to understand fiat currency is through coordination games.
The City Meeting Analogy
Consider a group of five friends deciding whether to meet in City A or City B.
Each person's happiness depends on how many of their friends choose the same city.
Possible outcomes:
- If 4 choose A and 1 chooses B → the person in B will switch to A
- If 3 choose A and 2 choose B → those in B prefer switching to A
- If everyone chooses A → nobody has an incentive to deviate
This situation represents an equilibrium.
Equilibrium
A situation where no individual has an incentive to change their decision given the decisions of others.
However, the same logic applies if everyone chooses City B. That outcome is also stable.
Thus, there are multiple equilibria.
This is a classic coordination game. Multiple equilibria exist, and the chosen equilibrium depends entirely on expectations.
Implication for currency
The value of money works in the same way.
A currency is valuable not because of its inherent qualities, but because everyone coordinates on using it.
If everyone accepts British pounds, they have value.
If people suddenly stopped accepting them, they would immediately become worthless.
Money works because everyone believes everyone else will accept it.
The belief itself creates the value.
4. Tangible vs Intangible Currency
Many people intuitively associate currency with physical objects, such as:
- Coins
- Banknotes
However, currencies do not need to be tangible. They can exist purely as entries in a record system.
This leads to an important insight: modern money systems are essentially accounting systems.
5. The Imaginary Pounds Example
To illustrate how intangible currencies work, consider a hypothetical society.
Desert Island Economy
Suppose a group of individuals lives on a desert island. To facilitate trade, the island’s chief creates a currency called Imaginary Pounds.
The system works as follows:
- Each person receives an initial allocation of 10 Imaginary Pounds.
- A central record called the Big Book of Transactions (BBT) tracks all balances.
- When a person purchases something:
- They propose transferring (x) Imaginary Pounds.
- The chief verifies that they have sufficient balance.
- The transaction is recorded in the BBT.
Thus, the currency exists only as entries in a ledger.
Ledger-based currency
A currency that exists purely as recorded balances in a transaction registry.
Why would people accept Imaginary Pounds?
If everyone else accepts the currency, individuals benefit from accepting it as well because it allows them to:
- sell goods today
- purchase goods later
This creates an incentive to accept the currency despite its lack of intrinsic value.
Accepting money is essentially accepting future purchasing power.
6. Scarcity and Money Creation
Two key principles determine whether a currency can function effectively.
6.1 Scarcity
The total quantity of currency must be limited.
If individuals possessed an infinite amount of the currency, it would be worthless.
Monetary scarcity
The requirement that the supply of currency be limited in order to maintain value.
The scarcity requirement reflects a basic economic principle:
if supply becomes infinite, the marginal value of the asset falls to zero.
6.2 Trust
Participants must trust the authority controlling the system.
In the desert island example, individuals must trust that the chief:
- accurately records transactions
- does not arbitrarily change balances
- respects the protocol
Without trust, the system collapses.
Money systems require credibility. If the authority issuing or recording money is not trusted, individuals will refuse to accept the currency.
7. The Role of Central Banks
In modern economies, the role of the island’s chief is played by central banks.
Central banks manage the monetary system by:
- issuing currency
- controlling money supply
- maintaining confidence in the system
The success of modern fiat currencies therefore relies heavily on public trust in institutions.
Monetary systems can be interpreted through the lens of institutional economics.
The value of fiat money depends on the credibility of the institutions responsible for issuing and regulating it.
8. The Emergence of Bitcoin
In 2008, an individual or group under the pseudonym Satoshi Nakamoto proposed a radical idea: a digital currency system that does not require a trusted central authority.
This proposal resulted in the creation of Bitcoin.
Bitcoin attempts to solve the trust problem by replacing institutional trust with cryptographic verification and decentralised consensus.
Key features include:
- digital-only currency
- decentralised network
- no central issuing authority
- transaction verification via blockchain technology
As of the mid-2020s, Bitcoin has reached market capitalisation levels on the order of trillions of dollars.
Bitcoin represents an attempt to replace institutional trust with algorithmic trust.
Instead of trusting a central bank, participants trust cryptographic rules and decentralised verification.
9. Conceptual Foundations of Cryptocurrencies
The key innovation behind cryptocurrencies is not simply digital money, but a system that allows digital money to exist without a central authority maintaining the ledger.
Traditional systems:
- ledger maintained by a bank or central institution
- trust required in the institution
Cryptocurrency systems attempt to replace this with:
- distributed ledgers
- cryptographic verification
- consensus mechanisms across networks
This shift represents a fundamental challenge to traditional monetary architecture.
10. Key Takeaways
- A currency is a commonly accepted means of payment.
- Currencies may or may not have intrinsic value.
- Modern money is typically fiat currency, whose value depends on collective acceptance.
- Currency systems can be interpreted as coordination equilibria.
- Money does not need to be physical and can exist purely as ledger entries.
- Effective currencies require scarcity and trust.
- Modern fiat currencies rely on central banks as trusted authorities.
- Bitcoin was created to eliminate the need for a trusted central intermediary through decentralised technology.
Exam Insight
If asked “Where does the value of money come from?” a strong answer should include:
- the coordination equilibrium argument
- the absence of intrinsic value in fiat money
- the role of trust and institutions
- the idea that money is a social convention sustained by expectations.
Bibliography
Nakamoto, S. (2008) Bitcoin: A Peer-to-Peer Electronic Cash System.
Vigier, A. (2026) Cryptocurrencies Lecture Slides. University of Nottingham.
Mankiw, N.G. and Taylor, M.P. (2023) Macroeconomics. 6th edn. London: Cengage Learning.