Volatility and Welfare in a Crypto Economy

Abstract

Proof-of-Work (PoW) blockchains possess at least two undesirable character- istics: 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 afore- mentioned points and also examines an alternative blockchain mechanism, Proof- of-Burn (PoB), that induces arbitrarily low volatility with arbitrarily enhanced welfare. PoB implements an active monetary policy that modulates cryptocur- rency demand shocks. Further, PoB employs a similar incentive structure as PoW but induces welfare gains by supporting cryptocurrency prices with blockchain updating expenses. This paper demonstrates that PoB maintains desirable PoW- characteristics such as free-entry and a deflationary monetary policy but does so without inducing undesirable PoW-characteristics such as exceptional volatility and welfare losses.