Just a quickie, in response to Benjamin Vitaris' article about Warren E. Weber's Bank of Canada Working Paper (pdf) (HT Tony Yates on Twitter). [Update: and read Tony's post, on commercial banks and lender of last resort, as a complement to this post.]
Suppose that Bitcoin totally replaces the Canadian Dollar (and every other currency) as medium of exchange. When people buy things, they always pay in Bitcoin. Does this mean the Bank of Canada and other central banks are powerless?
No. There are two ways the Bank of Canada could still conduct monetary policy:
1 By varying the amount of Bitcoin reserves it holds.
Central banks cannot change the total amount of Bitcoin in existence; but they can change the total amount of Bitcoin in public hands (in circulation).
If they want to reduce the stock of Bitcoin in circulation, to tighten monetary policy, they simply buy Bitcoin (in exchange for government bonds, or in exchange for any asset, like their own IOU) and add it to their stock of reserves. This is just like central banks borrowing Bitcoin, and they can vary the rate of interest they offer to pay to anyone who lends them Bitcoin. This is just like central banks buying back currency in an Open Market Sale of bonds and storing it in the basement, except they are buying back Bitcoin instead of currency. This is just like central banks buying gold in exchange for bonds, which is how they could tighten monetary policy in the olden days under the Gold Standard.
And if they want to increase the stock of Bitcoin in circulation, to loosen monetary policy, they simply do this in reverse, by selling Bitcoin and reducing their stocks of Bitcoin reserves. The only difference is that central banks can always print more currency but cannot print Bitcoin, so when they run out of reserves they cannot loosen any more. Bitcoin is like gold in that regard.
(This would probably work better for a large central bank, or a lot of small central banks acting together, because a central bank of a small country might have little effect on the world stock of Bitcoin in public hands, and it might flow across borders relatively easily.)
[Update (thanks to comments by JKH and JP Koning): see David Glasner's posts on the Bank of France accumulating gold reserves and tightening world monetary policy here and here. And my old post on how the Gold Standard worked based on David's post here.]
2 By doing "Dictionary Money".
Just because Bitcoin is the medium of exchange does not mean the dollar cannot be the unit of account. Prices could be posted in dollars, even if people actually pay in Bitcoin. Like American visitors to Canada sometimes pay in US Dollars for items priced in Canadian Dollars. And every day the Bank of Canada could simply announce a new definition to say what the words "Canadian Dollar" mean in terms of Bitcoin. If it wants to tighten monetary policy it announces that "$1" means more Bitcoin than it meant yesterday. If it wants to loosen monetary policy it announces that "$1" means fewer Bitcoin than it meant yesterday. Since the Bank of Canada could stabilise the value of the Canadian Dollar in terms of real goods by doing this (or continue to target 2% inflation), it seems plausible to me that the Canadian Dollar would continue to be the unit of account (instead of the very volatile Bitcoin) even though "Canadian Dollar" is just a name for a thing that doesn't exist. The Bank of Canada does not change the number of Bitcoin in people's electronic wallets, but it does change the number of Canadian dollars those Bitcoin represent.