Bitcoin as a Medium of Exchange

6 min read

What Is a Medium of Exchange?

A medium of exchange is a special type of good within an economy which is used primarily to facilitate the exchange of other goods and services.

Money has three defining features: it must be a medium of exchange, a store of value, and a unit of account. A given money might be better or worse at each of these functions, but all monies do serve these three purposes.

For example, the U.S. dollar is a highly liquid, widely-accepted medium of exchange and is a common unit of account for debt and goods, but it is a relatively poor store of value. On the other hand, Bitcoin is an excellent store of value, but has not yet achieved the liquidity required to be a medium of exchange or widespread use as a unit of account.

Bitcoin as a Medium of Exchange Today

Bitcoin already operates as a medium of exchange across the world. As the world’s first censorship-resistant money, Bitcoin excels as a medium of exchange in otherwise harsh legal environments, where authoritarian governments use the financial system to oppress their citizens. Protestors in Hong Kong, Belarus, and Nigeria have all used Bitcoin to protect themselves and their privacy after the local governments froze bank accounts and seized donations to their causes. Bitcoin’s inherent confiscation-resistance makes it most useful in such cases.

Learn more about current examples of using bitcoin as a medium of exchange.

Can Bitcoin Be a Global Medium of Exchange?

In more politically stable regions, Bitcoin has not gained the same traction as a medium of exchange. Some critics claim that this is an indication that Bitcoin has failed. This conclusion is short-sighted. In fact, the same factors that have slowed Bitcoin’s adoption as a medium of exchange ultimately make it the best money in history. The belief that bitcoin and the blockchain must be used for day-to-day payments to make Bitcoin a success is based on a fundamental misunderstanding of Bitcoin.

Gresham’s Law states that "bad money drives out good". In an economy with two monies, the bad money will be used in circulation, and the good money will be held as savings.

Bitcoin is a monetary network, more akin to a decentralized central bank than a payment processor such as VISA, PayPal, or Venmo. While the latter examples are more visible in society and more frequently used in daily payments, it is the monetary network, whether Bitcoin or a central bank, that determines how the entire system functions.

For this reason, Bitcoin’s adoption should not be measured by its use for commercial payments. The number of users, demand to send Bitcoin transactions, and the Bitcoin price are better metrics. Several factors explain why Bitcoin’s success is not predicated on its use as a method of payment for daily transactions.

Bitcoin Is Young

Bitcoin is barely a decade old as a project. It is useful to remember that in 2009, Bitcoin had a market capitalization of zero. In less than 13 years, that number has exploded to $1 trillion. Unseating well-established monies such as the U.S. dollar and achieving medium of exchange and unit of account status does not happen so quickly.

The Network Effects of Money

The network effects of money are stronger than any other good or network. Unlike social networks, monetary networks are mutually exclusive. While a user can use both Facebook and MySpace, a given amount of value cannot be invested in both Bitcoin and the U.S. dollar at the same time. This forces every individual to choose their monetary network and evaluate the opportunity cost of not joining others.

Additionally, the stakes for choosing the correct monetary network are far higher than other networks. If an individual chooses a bad social network, they might be bored, but if they choose a bad money, they will suffer financially. In cases of hyperinflation, when an entire monetary network collapses, this loss can be disastrous.

These factors make incumbent systems resilient to replacement by new competitors, even if they have some superior traits. For a new money to replace an old money, the challenger must be significantly better in order to overcome the network effects of the incumbent. However, when a monetary network fails, it fails suddenly and violently, and the last to leave are most harmed.

Learn more about Bitcoin’s Network Effects.

Bitcoin and Gresham’s Law

From an economic perspective, there exists a sound argument for why Bitcoin is not used as a method of payment today, and why that is a positive reflection on Bitcoin as a money.

Gresham’s Law states that “bad money drives out good”. In other words, in an economy where two currencies are in use, individuals will spend the money which is constantly devaluing and hold the money that retains its value. Thus, the bad money will dominate in terms of circulation and use in daily transactions, while good money will dominate in terms of savings and long term investment.

For example, in the case of Bitcoin, imagine an individual who holds both bitcoin and U.S. dollars. If they must spend money to buy goods, they should rather spend their dollars as it is constantly being inflated and devalued. If they were to spend their bitcoin, they would lose out on bitcoin’s potential future rise in valuation.

Thus, according to Gresham’s Law, there should be very little demand to spend bitcoin on day-to-day purchases while there exists a strong demand to accumulate and hold bitcoin for the long term. Indeed, this phenomenon is readily observable today.

So, when will this change?

Bitcoin will be used as a medium of exchange only when inferior monies are refused by merchants. Since governments typically make refusing their local currency illegal, this might take a long time, but in the meanwhile, Bitcoin will continue to succeed and gain adoption in other realms.

Medium of Exchange vs. Means of Payment

Another feature of money that should be taken into consideration is the difference between a medium of exchange and a means of payment. Money is a medium of exchange as it denominates the rate of exchange between any two goods. A means of payment, however, is simply the method of executing a specific exchange.

For example, if you buy a coffee in dollars, you might not pay in physical cash. Instead, you might use a credit card, an app, a gift card, or even loyalty points. All three of these are means of payment rather than money itself.

Similarly, Bitcoin can achieve the status of money and medium of exchange without being directly used in day-to-day transactions. Paper money, credit cards, or other tools can be denominated in bitcoin and used as means of payment. Layers on top of Bitcoin can also be used to execute Bitcoin payments without the Bitcoin blockchain.

Key Takeaways

  • A medium of exchange is a good which is used to facilitate the exchange of other goods.
  • Bitcoin has not yet been adopted as a widespread medium of exchange.
  • Use in commerce is not the most valid measure of success for a monetary network because of Greshman's Law.
  • Because bitcoin is hard money, whose value rises over time, people would rather spend fiat money, which loses value over time.