Cryptocurrency investment has historically been dominated by speculation. In 2017, nearly any idea could be turned into a whitepaper, a token contract, and a $50 million initial coin offering within a week. Investors ranged from everyday individuals to seasoned Bitcoin early adopters and Silicon Valley professionals—all caught up in the excitement of a bull market.
It wasn’t until the market turned bearish that many began reevaluating their investments. A fundamental misunderstanding was at play: cryptocurrencies should be valued not as stocks or commodities, but as currencies.
Fortunately, it is possible to assess cryptocurrencies based on fundamental utility. This approach offers more accurate valuations than speculative methods and can reveal promising investment opportunities.
Understanding the Equation of Exchange
Economists use the equation of exchange to model the behavior of currencies. It outlines the relationship between economic activity and the money supply. This model helps assign value to a currency based on its practical use as a medium of exchange—a core purpose of cryptocurrency.
The equation is expressed as:
MV = PQ
Here’s what each variable represents:
- M refers to the total units of currency actively circulating in an economy. Units held long-term without use are excluded.
- V stands for velocity, which is the average number of transactions each currency unit completes per year.
- P represents the average price of purchases within the economy.
- Q is the quantity of these average transactions conducted annually.
Given any three variables, the fourth can be determined. This makes the equation a powerful tool for currency valuation.
Applying the Equation: The US Dollar Example
Consider the US dollar. The M1 money supply includes all physical currency and demand deposits. According to the Federal Reserve of St. Louis, the velocity of M1 dollars ranges between 5.5 and 6 transactions per year. For this example, we’ll use a velocity (V) of 6.
Assume the average purchase (P) in the US is $50, and the annual quantity of such purchases (Q) is 20. The total purchase value (PQ) is:
$50 × 20 = $1000
According to the equation, MV must also equal $1000. With V known to be 6, we solve for M:
M × 6 = $1000
M = $1000 ÷ 6
M = $166.67
This result represents the monetary base required to support this level of economic activity.
Applying the Model to Cryptocurrency: WidgetCoin Case Study
Imagine a company, WidgetCorp, that sells widgets for an average of $20 each. Customers buy 500 widgets per year, resulting in an annual transaction volume (PQ) of:
$20 × 500 = $10,000
Now, suppose WidgetCorp introduces its own currency, WidgetCoin (WGC), and mandates that all widget purchases be made using it. In this closed system, the velocity (V) of WGC is estimated at 4 due to some user reluctance to spend.
Using the equation:
M × 4 = $10,000
M = $10,000 ÷ 4
M = $2,500
This means the total value of circulating WGC must be $2,500 to support the widget economy.
To find the intrinsic value per WGC, we need the circulating supply. If WidgetCorp issued 12,500 coins, each coin would be worth:
$2,500 ÷ 12,500 = $0.20
If, instead, 1 million coins were issued, the value per coin would drop to:
$2,500 ÷ 1,000,000 = $0.0025
An initial sale of WGC at $0.20 would lead to significant losses for investors once the market adjusts to the true utility value.
Why Cryptocurrency Markets Experience Volatility
This model explains much of the volatility seen in cryptocurrencies like Bitcoin. When market prices deviate from intrinsic, utility-based values, corrections eventually occur. In largely speculative markets, necessary purchases (PQ) are limited, leading to price instability.
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For a deeper dive into applying these principles to major cryptocurrencies, further research and structured analysis are recommended.
Practical Implications for Investors
The equation of exchange isn’t just theoretical—it offers practical insights for evaluating cryptocurrencies. It emphasizes the importance of utility and circulation rather than pure speculation.
During market downturns, currencies with strong use cases and well-designed tokenomics are more likely to endure. Understanding these dynamics can help investors make more informed decisions.
Frequently Asked Questions
What is the equation of exchange?
The equation of exchange, MV = PQ, is an economic model that relates the money supply (M) and its velocity (V) to the average price level (P) and quantity of transactions (Q). It is used to determine the fundamental value of a currency based on its utility.
How can this equation be used to value cryptocurrencies?
By estimating the velocity (V), average transaction price (P), and quantity (Q) within a cryptocurrency’s economy, you can solve for the required monetary base (M). Dividing M by the circulating supply gives the intrinsic value per unit.
Why do cryptocurrencies often trade above their intrinsic value?
Market speculation, investor sentiment, and external factors can drive prices above utility-based valuations. However, these disparities often correct over time as the market matures.
What is token velocity, and why is it important?
Velocity refers to how frequently a token is used in transactions within a given period. High velocity may indicate strong utility but can also reduce per-token value if the supply is large. Low velocity might suggest hoarding or low adoption.
How can investors identify cryptocurrencies with strong utility?
Look for projects with clear use cases, active user bases, and sustainable tokenomics. Analyzing transaction volume, circulation patterns, and economic activity within the ecosystem can provide valuable insights.
Can the equation of exchange predict short-term price movements?
No, this model is designed for long-term fundamental valuation. Short-term prices are influenced by market sentiment, news, and speculation, which are not captured by this equation.