Bitcoin deflation explained

One of the main properties of Bitcoin is that only a predefined fixed number of coins will come into existence. There will never be more than 21 million Bitcoins. This turns Bitcoin into a deflationary currency by definition. Deflation is the state where price levels decrease over a period of time, and a Bitcoin would thus become more valuable. This can be verified by considering the quantity theory of money, which captures the relationship between the supply of money, price levels and inflation. The equation that represents this relationship is M * V = P * Y where M is the money supply, V is the velocity, P is the price level, and Y is the quantity of output. For easier calculations, this can be converted to a percentage change formula and then the equation becomes (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in quantity of the output).

Equation inputs

At the start it was established that the percentage change in money supply will be zero once 21 million coins have been mined. The output is represented by the nominal Gross Domestic Product (GDP) given by P * Y, and the quantity of the output can be assumed to be increasing. The reason for this is that without growing production, people will lose their jobs and poverty will spread. To keep the employment rates stable, an economy has to grow by at least two percent. This is the consequence of growing efficiency due to technology. If the production would remain stable with increasing efficiency, it means technology has replaced a certain number of people.

The velocity of money is the number of times one Bitcoin is spent to buy goods and services per unit of time. In other words, it represents people’s spending habits or the rapidity at which money is spend or invested. This variable has only a slight impact on the equation, as people’s spending habits are not quick to change. Velocity is thus relatively constant in the long run.

Impact on price

It can now be determined that the left hand side of the equation (percent change in the money supply) + (percent change in velocity) is relatively constant in total. As the quantity of the output is increasing, the right hand side of the equation can only be equal if prices are falling. We’ve got deflation. As Bitcoins will be worth more in a certain amount of time, it will also cause a negative pressure on the velocity of money. After all, if a Bitcoin will become worth more there is an incentive to delay spending it. Prices must then fall more rapidly, further increasing the deflationary effect.

Take a second to support Digiconomist on Patreon!
Become a patron at Patreon!