Bitcoin’s price volatility or the value of Bitcoinhas left many skeptics questioning its economic and mathematical underpinnings as well as searching for a generalized explanation of its value.
Due to its decentralized nature, Bitcoin follows no monetary policy and is not backed by any asset or government. It creates skepticism among consumers and investors, who appreciate the price stability signals a fiat currency is granted by government policy.
Bitcoin Supply and Demand
The price of Bitcoin is determined by supply and demand, just like the price of the U.S. dollar. The price of bitcoin increases when the demand for it increases, similar to fiat currency. The price of bitcoin falls when demand for it falls.
Due to its absolutely inelastic supply schedule, Bitcoin is a unique asset in the sense that it is utterly immune to fluctuations in demand. The producers of most goods, including fiat currency and gold, respond to an increase in demand by increasing production and bringing prices to an equilibrium. The difficulty adjustment ensures that the production of new bitcoin does not increase when demand for bitcoin rises.
Stock-to-flow (S2F) models are commonly used to determine the impact of scarcity on asset values. Stock-to-flow is a ratio that indicates how long it will take to produce the current stock at the current production rate. As a rule of thumb, the stock-to-flow ratio is the inverse of the inflation rate of a particular asset. Stock-to-flow ratios that are higher should lead to higher prices, according to the model.
What are the effects of Bitcoin’s scarcity on its price?
Bitcoin, unlike fiat currency, has a finite supply. At any one time, no more than 21 million Bitcoins will be in circulation. A fixed number of Bitcoins are created each day, and that number decreases overtime, causing demand to outpace supply. This further increases the price.
In addition, Bitcoin’s future monetary policy is absolutely known, giving investors great assurance that inflation will be introduced or increased in the future.
On the other hand, the creation and distribution of fiat currency are potentially infinite and unpredictable. The goal of most central banks is to keep inflation low, but these rates can be changed by a small committee at any time, and the true inflation rate of fiat currencies is nearly impossible to determine.
Because of its finite supply and small market cap, Bitcoin’s price is also much more sensitive to changes in demand, resulting in a higher degree of price volatility.
The inflation and deflation of prices
Inflation occurs when the velocity of money or the supply of money rises rapidly, causing prices to rise and the value of currency to decrease. Bitcoins are deflationary due to the limited supply they possess. They prevent hyperinflation due to their finite supply. Governments’ ability to print unlimited amounts of currency has led to periods of hyperinflation that have driven the value of many fiat currencies to zero, including the German Mark and Zimbabwean dollar.
It has always been supplying and demand that correct deflationary events in fiat currency and bitcoin. Deflationary spiral concerns are unfounded or unsupported by economic theory. Due to its finite supply, Bitcoin is also a secure long-term store of value, comparable and sometimes even better than gold. But make sure once you start buying Bitcoins, store them in a safe Bitcoin wallet.