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Exchange Rate Stability and Economic Growth in Virtual Economies
Garrett Keirns
Department of Economics, Xavier University, Cincinnati, USA
keirnsg@xavier.edu
May 2013

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Abstract
Empirical evidence suggests that exchange rate volatility has historically mitigated economic growth.
The goal of this paper is to confirm this hypothesis as well as apply it to the new virtual economy. Using
data gathered from previous studies I present the argument that the economic relationship that exists
between exchange rate volatility and economic growth in the “brick and mortar” economy is also
present in the virtual economy. I define the virtual economy as the sum of all financial transactions that
take place online. I then present the case of Bitcoin, a new virtual currency, and show how the
hypotheses proposed in the first stage of the paper are translating themselves into reality.
Keywords: Bitcoin, currency, cryptography, fiat, finance, risk, volatility
Contents
1. What factor does exchange rate stability play in economic growth? Does a
decrease in volatility increase productivity?
2. What is the virtual economy? How does capital flow through the internet?
3. What is Bitcoin? What is Bitcoin’s role in the virtual economy?
4. Can the insights gained from volatility research in traditional economies
be translated to the Bitcoin economy?
5. Beyond Bitcoin: The Future of Cryptographic Currencies.
6. Conclusion

3. 3Keirns
What factor does exchange rate stability play in economic growth? Does a
decrease in volatility increase productivity?
Empirical evidence suggests that exchange rate volatility has historically mitigated economic
growth. Volatility skews investors’ expectations of the future making it more profitable to have a “wait
and see” approach to developments of a market that they are trying to enter. For example, if investor A
wants to purchase a fixed income security in market X but is unable to hedge his exchange rate risk his
total return on his investment is unknown because he cannot accurately predict what the exchange rate
will be. Many institutional investors are bound to report their earning in a particular currency so
convertibility between currencies is important. The objective of a great deal of economic research is
quantifying what type of impact that the volatility of an exchange rate will have on an economy. This is
useful from a policy standpoint because governments and central banks can use this information to
formulate monetary policies that reduce volatility, such as adopting floating exchange rate regimes and
curbing inflation through currency repurchases.
Exchange rate volatility is usually measured as the average deviation from an average exchange
rate measured over a specific period of time. Thus, a currency that typically trades in a broad range from
its moving average is considered more volatile than a currency that trades in a narrow range. The cause
of this is market forces. Like any other tradable commodity, currency prices are an equilibrium of supply
(people trying to sell a currency) and demand (people trying to buy a currency). If buyers and sellers do
not have similar needs in a currency market then that market will be more volatile. Liquidity provided by
market makers makes markets less volatile because the market makers are willing to compromise with
buyers and sellers and take on additional exchange rate risk in return for the ability to make a profit in
the market when conditions (parity between buyers and sellers) improve.
As stated earlier, I draw upon previous empirical research to formulate my hypothesis that
decreasing exchange rate volatility will have a positive effect on an economy. I draw on real world
studies that look into the relationship of exchange rate volatility and foreign direct investment. Some of
the papers focus on the effects of exchange rate volatility in a specific country such as the work of
Amaghionyeodiwe (2009) and his study on the impact of foreign exchange rate volatility on foreign
direct investment in Nigeria. Other papers are broader in scope such as the paper published by the
European Central Bank in 2007 on exchange rate volatility and growth in small open economies at the
EMU periphery. In the case of the Nigerian economy, there was found to be a strong relationship
between the variability of the Naira (NGN) to major world currencies and the amount of FDI in the
country. The ECB paper also concluded that exchange rate stability is a sign of a healthy economy and
will therefore attract more outside investment which will further develop the economy. A paper
published by Aranyarat (2011) looks at the effect of foreign exchange rate volatility and foreign direct
investment in Thailand. The author found that volatility is statistically significant for machinery and
transportation, chemicals, food, and finance.

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What is the virtual economy? How does capital flow through the internet?
Just as money circulates in the traditional “brick and mortar” economy as bills, paper notes and
electronically, money flows through the internet creating a virtual economy. The virtual economy is the
sum of all financial transactions that take place online. For example, a purchase of clothes on eBay
would be considered a transaction that takes place in the virtual economy. The virtual economy is not
limited to just commerce. Players of online-video games often trade inside the game and settle debts on
the internet using real money. Remittance payments across borders that are settled entirely
electronically are also considered to be part of the virtual economy. Actually, any transaction that can
take place remotely and without either party having to physically meet the other person could be
considered to be counted in the virtual economy. The growth of the internet has stimulated the growth
of these types of transactions. Growth of the virtual economy over the past few years has been
exponential as a greater share of commerce has become electronic. Services such as PayPal,
Moneybookers, and Skrill allow users to transfer money over the internet using credit cards and bank
balances. Many banks now offer free instant inter-bank transfers to account holders. The whole
financial landscape is becoming much more high-tech allowing money to move much more quickly than
before.
Like the brick and mortar economy, capital moves through the virtual economy in predictable
flows. Consumers move money from banks or credit cards onto the internet to merchants who in turn
return that money back into the banking system to cover their costs of doing business. Some of that
money remains online to pay for virtual infrastructure such as web hosting costs and online advertising
costs. For video-gamers, money moves from offline to online in order to pay for virtual goods and is then
either returned to the brick and mortar economy or kept online. The same is true for remittance
payments, money that is obtained from doing work in the brick and mortar economy is brought online
and then sent to the receiving party usually being transferred offline again to be used to pay for living
expenses.
An interesting aspect of the virtual economy is that the electronic nature of transactions means
that more information about transactions is recorded and can be analyzed. In the brick and mortar
economy many transactions go unrecorded because of the use of cash or because people decide not to
record the transaction. Being electronic, the virtual economy captures more information than the brick
and mortar economy allowing a greater depth of information for dissecting and analyzing economic
phenomena such as capital flows.
What is Bitcoin? What is Bitcoin’s role in the virtual economy?
Bitcoin acts as a decentralized internet currency that facilitates online trade. Bitcoins are
“mined” meaning that a network of computers solves complex algorithms that process transactions on
the Bitcoin network in return for receiving new Bitcoins. These Bitcoins are created in a predictable
pattern thus mitigating inflationary concerns. There will only be 21,000,000 Bitcoins created. The
network regulates the number of Bitcoins created by changing the difficulty of the algorithms that are
required to receive new Bitcoins. This is called “network difficulty.” If there is a sudden influx of

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processing power on the network difficulty will increase thus maintaining the predictable mining of new
Bitcoins. Currently, as March 2013, there are 11 million Bitcoins in circulation. Bitcoins are mined in
“blocks.” When the complex algorithms of the block are solved the computer providing the processing
power receives a certain number of Bitcoins. Currently a mined block will yield 25 Bitcoins (BTC).
However, in the past that number was greater and in the future the number will shrink until all the
Bitcoins have been mined. At the point when all Bitcoins are mined, processing power on the network
will be compensated by paying out transaction fees. Below is a chart1
depicting the total number of
Bitcoins that will be in circulation. All 21 million Bitcoins will be mined by the year 2030; at that time
traditional Bitcoin mining will become obsolete and the network will switch to a fee-only infrastructure.
The creation of the Bitcoin is credited to a pseudonymous developer named Satoshi Nakamoto.
In a 2008 paper he describes his vision of a peer-to-peer, electronic payments system written in an
open-source code. The production of transfer is based on public-key encryption. Essentially, each Bitcoin
is assigned an encrypted code that can only be recognized by the central log that keeps track of each
transaction. This central log is known as the blockchain and is being constantly updated as new
transactions take place. A copy of the blockchain is archived and all transactions are recorded. Bitcoins
can be received using a Bitcoin wallet. A wallet is software that recognizes the encrypted keys and is
able to synchronize with the blockchain, thus confirming transactions that take place.
The value of a Bitcoin is determined by the free market. Many Bitcoins are traded on centralized
exchanges. Exchanges act as the intermediary between Bitcoins and fiat currencies such as US Dollars
1
Taken from www.bitcointalk.org

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and Euros. Unlike the network itself, Bitcoin exchanges are centralized locations where trade takes
place. In practice, Bitcoins are transferred to an online wallet held with an exchange where they can be
traded for fiat currency. The fiat currency can then be wired to a bank account. In the United States,
some exchanges offer payouts using the Automated Clearing House network (ACH) meaning that they
are directly deposited into a bank account following a 3-4 business day clearing period. Currently, the
largest Bitcoin exchange is located in Tokyo, Japan. Mt. Gox handles nearly 80% of all Bitcoin/Dollar
transactions.2
In March of 2013 there was roughly $122 million worth of trade volume on Mt. Gox alone.
This represents a 1333% increase in transaction volume from the same period in 2012.3
Bitcoins use in the virtual economy is growing daily. At its inception Bitcoin was used only by a
handful of programmers. Bitcoins traded for under a $1 each as recently as April 2011. As more people
learned about Bitcoins there use became more popular. The anonymous aspect of Bitcoin has been one
of the reasons it has become so popular. The internet site Silk Road which is hosted on an anonymous
network called Tor specializes in selling illicit drugs using Bitcoin as the currency to process transactions.
Independent research speculates that the site created $11 million in revenue in 2011 alone. Bitcoin also
has a strong presence in social media. Bloggers on WordPress.com can receive donations in Bitcoins.
Wikileaks.com accepts Bitcoin donations to cover its operating expenses. There are a handful of real-
world merchants who have begun accepting Bitcoins. There are websites that archive data about these
real world merchants. There have been talks of developing Bitcoin ATM machines where users deposit
fiat currency in exchange for Bitcoins.
2
Information from www.mtgox.com
3
Transaction volume figures gathered from www.bitcoincharts.com

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Can the insights gained from volatility research in traditional economics be
translated to the Bitcoin economy?
Many of the empirical studies on exchange rate volatility point to the fact that excessive
volatility has the effect of decreasing economic growth. The excessive volatility has the effect of
decreasing FDI inflows which are necessary in helping small economies develop. I hypothesize that the
same is true for Bitcoin. Thus, excessive volatility of the Bitcoin exchange rate will have a negative
effect on the growth of the Bitcoin economy and will mitigate Bitcoin’s utility as a medium of
exchange. To further explain this we first need to understand the difference between Bitcoin and
traditional fiat currencies. We also need to understand the causes of exchange rate volatility. A fiat
currency is any currency created by a government. It usually gains its legal tender status from the fact
that it can be used to pay taxes. Fiat currencies do not have any other backing other than the faith and
credit of the issuing country. Many governments hand over the power to create and destroy fiat
currencies to a semi-independent central bank. The bank creates monetary policy and decides the
direction that the currency will take. Consumers and producers rely on traditional fiat currencies for
three things 1.) a unit of account, 2.) a store of value, and 3.) a medium of exchange. Sometimes,
however, a central bank caves into pressure from the government to pursue policies that satisfy short-
term desires instead of upholding the integrity of the currency for future generations. Mismanagement
of the currency supply skews investors’ expectations and usually leads to a devaluing of the currency in
the form of inflation. Less likely is a scenario when holders of a currency believe that a currency will
appreciate in value and therefore the incentive to hold the currency is greater than spending, this causes
deflation.
Volatility occurs in currency markets when central banks mismanage the money supply. This
causes a rational fear in investors who want to maintain the real value of their assets. Panic buying and
selling can occur after a central bank announces its intentions of the future value of a currency. The
excessive buying and selling cannot be matched with others who want to take on the same trades,
therefore creating a greater deviation from the normal trading price. This deviation is known as
volatility. In the developed world this is usually not a problem because central bankers have sufficient
independence from political pressures and are well educated in maintaining a façade of integrity in their
money supply. However, in smaller and more developing countries there is a pressure to cave in to
political pressures and overlook long term integrity in exchange for a short term fix. Furthermore, in
these less developed countries there is less economic diversification. This has the effect of amplifying
economic shocks.
Bitcoin is similar to fiat currencies in that it can be used as a unit of account, store of value, and
medium of exchange. The utility of the Bitcoin is entirely dependent upon creating maintaining an
efficient market between Bitcoins and fiat currencies. An efficient market is one in which volatility is
contained in a narrow and predictable range. The model below explains this concept graphically:

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As Bitcoin becomes more popular and breaks into the mainstream as a currency of choice for
online transactions I expect volatility to decrease. If, on the other hand, volatility doesn’t decrease as
Bitcoin becomes more popular and actually becomes more volatile the utility of the currency as a
medium of exchange will decrease. Why would merchants want to accept a currency if they don’t know
what its value will be at the end of the day? Implied volatility will still exist in the Bitcoin market. This is
because it would be impossible to eliminate all volatility in a market without pegging it to another unit
of value. However, I accept implied volatility to be an acceptable attribute of the currency especially as
the Bitcoin economy becomes more financialized.
Another scenario that could be devastating for the Bitcoin is the occurrence of hyper deflation.
Already in its short history Bitcoin has experienced bouts of hyper-deflation that occur as a result of
speculative buying. When hyper-deflation occurs Bitcoin loses its utility as a medium of exchange but
gains utility as a store of value. Hyper deflationary episodes are usually caused by a speculative uprising.
When the exchange rate is rising fast enough holders of Bitcoins have little incentive to convert their
Bitcoins back into fiat currencies because there is the expectation that they will be able to receive more
fiat in the future if they keep holding their Bitcoins. This is detrimental to the Bitcoin economy because
it causes a slowdown of trade in the currency. Eventually, if the exchange rate doesn’t return to
equilibrium the Bitcoin market will lose liquidity as people will stop offering to trade Bitcoins for Dollars.
This will in turn cause a devaluation which will restore the Bitcoin exchange rate to a more sufficient
level.

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Above is a price graph of the Bitcoin to US Dollar exchange rate from May 2011 to March 2013
taken from Mt. Gox, the largest Bitcoin exchange by volume. The arrows point to hyperdeflationary
periods. As you can see, the market quickly corrected these deflationary uprisings rather quickly,
strengthening my hypothesis that the Bitcoin/fiat exchange market is rational and understands Bitcoin’s
utility as a medium of exchange. In March 2013 speculation caused by the growing popularity of Bitcoin
caused the price to spike to a high of $265 per Bitcoin. When the bubble popped the price experienced
rapid decline losing over 50% in a single day. This kind of volatility isn’t normal for the Bitcoin market.
Since its inception, Bitcoin has enjoyed a steady increase in its exchange rate. This is because as more
people begin using Bitcoins the demand for the coins will naturally cause the price to rise. Short term
fluctuations are a result of discrepancies between buy and sell orders. Much of the sell pressure is a
result of payment processors such as BitPay, Inc. liquidating Bitcoins in order to credit merchants’
account with dollars after they have received Bitcoins.
USD/BTC Volatility Statistics (4/14/2011-4/16/2013)4
Avg. Price
Deviation
(24 h)
Standard
Deviation
Max Up Move
(5/10/2011)
Max Up Move
Std. Dev.
Max Down
Move
(6/11/2011)
Max Down
Std. Dev.
4.13% 6.00% 52.89% 8.13 -38.83% -5.78
Currently, Bitcoin is more volatile when compared to the currencies of developed economies
and is more volatile when compared to commodities like gold. I attribute this to the youth of the
market. As the market capitalization of Bitcoins increase I expect volatility to decrease. I attribute this to
greater liquidity and greater number of traders willing to risk their capital to see Bitcoin succeed. Lax
regulation also contributes to the overall volatility of the market. Since there is no governing body
controlling Bitcoin it is one of the last truly free markets in existence. Exchanges may halt trading during
times of excessive volatility and this helps to mitigate panic selling. However, Bitcoin transactions occur
4
Information taken from Mt. Gox Bitcoin Exchange, Mt. Gox has historically had the highest trade volume and
captures about 80% of all USD/BTC trade as of 4/13.

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with relatively little government scrutiny. Going forward I believe that the financial landscape of the
Bitcoin economy will become increasingly sophisticated. Since one of the catalysts to mainstream
adoption will be a decrease in volatility, growth in the area of Bitcoin financial derivatives will help drive
larger volumes of trade onto the network. There already exist ways of hedging exchange rate risk such
as the MPex securities exchange5
and the ICBIT Bitcoin Exchange and Futures Market. Currently, these
markets are relatively illiquid and hedging positions is expensive because of the high volatility. However,
as the BTC/USD market becomes more mature these types of contracts will become invaluable for
merchants who want to enter the Bitcoin economy but previously haven’t been able to because they
cannot handle the exchange rate risk.
Beyond Bitcoin: The Future of Cryptographic Currencies.
Even if Bitcoin ultimately doesn’t succeed the lessons it has taught us about virtual
decentralized currencies will prove invaluable going forward. The Bitcoin model can easily be copied and
there are already competing virtual currencies such as LiteCoin6
and DevCoin7
. One of the main factors
that has set Bitcoin apart from previous virtual currencies is that it relies on advanced cryptography. This
cryptography, once reserved only for highly advanced computers, was used by governments to transfer
internal wires with the objective of maintaining secrecy. With the advent of the internet and the
development of the micro-processor this once esoteric technology is becoming a household staple.
The applications of Bitcoin are numerous. Application developers have already created
numerous apps that integrate Bitcoins. It is now very easy to have Bitcoins loaded onto a smartphone.
The transactions that take place on smartphones utilize new Quick Response (QR) code technology. This
makes transacting money as simple as taking a picture of a pixelated box image. Transaction processing
costs using this technology are cheaper and quicker than traditional credit card networks such as Visa,
MasterCard, and Discover.
Bitcoin’s utility brings up serious questions about regulation in the realm of financial
transactions. Given Bitcoin’s anonymity aspects there is the possibility that Bitcoins can be used to
evade taxes and conduct other illegal activity. Many exchanges are required to adhere to strict Anti-
Money Laundering (AML) and Know Your Customer (KYC) guidelines to prevent the transfer of funds
derived from illegal activities. However, given the decentralized nature of a network operating in
multiple jurisdictions this poses considerable problems to governments worldwide trying to control the
flow of illegal funds. An interesting example of Bitcoin’s independence from governmental regulation
takes place in Argentina. As of March 2013, the government of Argentina has restricted the flow of US
Dollars into the economy in an effort to curb Argentine Peso (ARS) inflation. This has created a vibrant
underground market for the US Dollar which is still the currency of choice for the real estate market. The
5
MPex.co is a Bitcoin securities exchange run by Romanian mathematician Mircea Popescu. The site provides put
and call options on various USD/BTC strikes.
6
Litecoin.org
7
From Devcoin official site

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“Dolar Blue” is the price at which a US Dollar can be bought unregulated merchants in Argentina and the
exchange rate is considerably higher than official published figures. This has caused some Argentinians
seeking US Dollars to use Bitcoins. Argentinians will find traders willing to accept Pesos for Bitcoins and
will then trade Bitcoins for US Dollars, effectively bypassing the government’s efforts at currency
controls.
Governments that exercise excess control over citizens will have a hard time with Bitcoin. In
countries such as China and Iran Bitcoins are being used to purchase products from countries like the
United States. In the United States, there is the possibility that citizens can use Bitcoins to conduct
business with merchants in countries that the government has blacklisted. Potentially, if these types of
activities develop, Bitcoin could undermine trade agreements and economic pacts between nations. This
is what makes the legality of Bitcoin so unclear. In March 2013, FinCEN, a department of the United
States Treasury, released a statement outlining the steps that users of virtual currencies must take to
maintain compliance with the US government. Users who purchase virtual currencies to buy goods or
services are not required to file any paperwork with the government. However, individuals involved in
the selling of virtual currencies to others are required to file as a Money Service Business (MSB) with a
number of local authorities. With the registration is the understanding that individuals conducting this
type of business will comply with AML and KYC protocol.
The future of the virtual economy is bright with potential. In the future, Bitcoin may not be the
currency that defines the virtual economy but it will certainly go down as the catalyst that started the
revolution. The challenges that face Bitcoin are numerous. Governments will assert that they are the
only entities with the sovereign authority to maintain currencies and may try to illegalize Bitcoin and its
imitators. The traditional banking cartel will try hard to maintain its dominance and will work hard to
discourage integration between the banking system and Bitcoin. Given these circumstances, however, I
believe that virtual currencies will ultimately succeed because at their core they are beneficial to
promoting human trade and interaction.

12. 12Keirns
Bibliography
Academic Papers
Aranyarat, Chonnikarn. The Effect of Exchange Rate Volatility on Foreign Direct Investment and Portfolio
Flows to Thailand. Chulalongkorn University. N.p., n.d. Web.
Barber, Simon, Xavier Boyen, Elaine Shi, and Ersin Uzun. "Bitter to Better
—How to Make Bitcoin a Better Currency." Palo Alto Research Center, University of
California, Berkeley(2012).
Nakamoto, Satoshi. "Bitcoin: A Peer-to-Peer Electronic Cash System." (n.d.): n. pag. Web.
OSINUBI, Tokunbo S., and Lloyd A. AMAGHIONYEODIWE. "FOREIGN DIRECT INVESTMENT AND
EXCHANGE RATE VOLATILITY IN NIGERIA." International Journal of Applied Econometrics and
Quantitative Studies 6.2 (2009): n. pag. Web.
SCHNABL, GUNTHER. "EXCHANGE RATE VOLATILITY AND GROWTH IN EMERGING EUROPE AND EAST
ASIA." CESIFO WORKING PAPER NO. 2023 (2007): n. pag.
Vergil, Hasan. "Exchange Rate Volatility in Turkey and Its Effect on Trade Flows." Journal of Economic
and Social Research 4.1 (n.d.): 83-99.
Internet Sources
"Bitcoin." Wikipedia. Wikimedia Foundation, 05 May 2012. Web. 03 May 2012.
<http://en.wikipedia.org/wiki/Bitcoin>.
"Bitcoin Charts." Bitcoin Charts. N.p., n.d. Web. 24 Apr. 2013
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"Home Most Recently Mined Blocks in the Bitcoin Block Chain." Bitcoin Block Explorer. N.p., n.d. Web. 24
Apr. 2013.
"Powerful." CampBX Bitcoin Trading Platform. N.p., n.d. Web. 24 Apr. 2013.
"Trade with Confidence on the World's Largest Bitcoin Exchange!" Mt.Gox. N.p., n.d. Web. 24 Apr. 2013.

13. 13Keirns
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