A frequently argued advantage of bitcoin over modern fiat currencies is that it is deflationary. The Bitcoin community maintains that it is superior to both fiat money and gold due to its pre-determined limited supply. This means that the value of bitcoin should increase relative to goods and services as the economy grows. This fall in the price level of goods and services relative to bitcoin is known as “deflation”. In this note, we explore what this means, and what the economic implications are of a deflationary money.
Bitcoin: Money Supply and Deflation1
The Bitcoin protocol limits the number of coins that will ever exist – i.e. the money supply – to 21 million. More precisely, it creates a fixed supply curve over time, since Nakamoto specified that the reward for adding a new block is to be halved every 210,000 blocks. Hence, the reward will shrink to zero when the limit of 21 million is reached. At that point, the maximum number of units will have been reached and no new bitcoin will be mined. This also implies that the number of circulating bitcoin will decrease over time due to accidental (or voluntary) withdrawal from the circulation of units – for example, if someone forgets their private key. A similar design is enforced for many other cryptocurrencies, which also have a limit to the overall number of coins mined.
This type of protocol creates a monetary policy based on scarcity. The first implication of a fixed money supply in a growing economy is that the real value of one bitcoin has to rise over time, as it becomes increasingly scarce relative to the goods and services for which it is exchanged. Even after adjusting for a possible increase in velocity of circulation of bitcoin, this suggests deflationary prices, hence, the deflationary nature of bitcoin. A second implication is that, as the money supply is completely inelastic, all shocks to money demand must be reflected in prices. Hence, prices are potentially more volatile.
Gold Standard and Modern Fiat Money
Under the gold standard, all currencies were pegged against the dollar that, in turn, was pegged against gold. Hence, the world price level was pinned down by the demand and supply for monetary gold. This was determined by gold production and the demand for gold for both monetary and non-monetary use. The supply of gold was rather rigid but not fixed, and therefore the marginal cost of mining gold anchored the price level in the long run. In the short run, some correction mechanism was at work. After large gold discoveries, a period of global inflation would start, driving up prices as the real price of gold fell. This in time led to a cut in gold production and increased substitution from monetary gold to non-monetary gold. In fact, the expected inflation rate was around zero and long-run price uncertainty was low. In the short run, inflation rates depended on the limited ability of central banks to offset demand and supply shocks of gold.
Modern fiat money, that is money that it is not linked to gold or any other commodity, is generally inflationary. Central banks follow an explicit target for the inflation rate over the medium-term, usually two percent, and adjust short-term interest rates in order to achieve this target. The change in short-term rates is transmitted though the yield curve and affects investment, saving and consumption decisions - and in turn prices. Over time, prices grow at a fixed rate and, in the short-medium run, the inflation rate is kept under control to ensure that supply and demand shocks do not result in high price volatility.
Types of Deflation
Deflation has historically come in different forms - some good, and some bad. Good deflation can happen due to positive supply shocks that increases productivity and lower prices. The economy sees lower product prices accompanied by higher profits and higher asset prices, but also rising real wages. Bad deflation happens in recessions, often due to lack of demand. Things are worse in deep recessions when prices drop steeply: there is a feedback loop between the lack of aggregate demand, falling aggregate supply, and the financial channels which support them. This negative feedback loop leads to increasing real debt and can drag the economy down further. This can possibly lead to a liquidity trap, where people hold more cash because they expect further deflation. In such a situation, the economy’s equilibrium real interest rate becomes negative, and even with a near-zero nominal interest rates the economy cannot stabilise itself.
What is the Optimal Level of Inflation / Deflation?
From a theoretical perspective, the optimal inflation rate should be quite low - a fairly moderate inflation or deflation rate.
The famous Friedman’s inflation rule advocates setting the nominal interest rate at zero, and hence a negative inflation rate equal to the long run growth of the real economy. To this goal, the central bank must target a rate of deflation equal to the real interest rate (the long run economic growth rate). The logic is that the opportunity cost of holding money should equal the social cost of creating additional fiat money. In fact, in an economy with fully flexible wages and prices, the costs of inflation are due to the opportunity cost of holding money balances. Similar results can be obtained in more formal modelling settings (Chari et al., 1991. Schmitt-Grohé and Uribe, 2001).
However, when assuming the economy to be subject to nominal price stickiness, then the optimal inflation rate is generally higher. For example, with uniform price stickiness the optimal inflation rate would generally be zero. In the presence of downward nominal wage inflexibility, since employees normally resist a cut in their nominal wage, a positive inflation rate would be optimal (Akerlof, Dickens and Perry, 1996).
A key observation here is that a very desirable property for inflation is predictability. When inflation is predictable, borrowers and savers take expected inflation into consideration when negotiating interest on loans, or setting the price of bonds and risky assets. Unexpected inflation movements, instead, shift wealth between borrowers and lenders. Hence volatility in inflation increases risk premia and feeds into interest rates and asset prices.
Central Banks and Inflation
Modern central banks look at deflation as a policy failure and a complicated scenario. This is mainly due to the presence of a zero or effective lower bound below which the nominal interest rate cannot be lowered. This makes the policy interest rate an ineffective tool for policymaking. Such a situation would impede central banks from undertaking counter-cyclical policy actions, reducing their ability to smooth the business cycle.
In such a view, the optimal average inflation rate depends on the real interest rate. For a given inflation rate, a lower steady-state real rate implies that the nominal interest rate will hit its lower bound more frequently. Hence a higher inflation target may be advisable (see Andrade et al, 2019).
Economists and central bankers tend to believe that a low, stable, and predictable inflation rate is highly desirable. This is because business and consumers can make long-term plans with little uncertainty, and lower interest rates are possible. In turn, lower interest rates support investments and durable goods purchases. Modern central banks target a stable and low inflation level that gives them room for countercyclical policy actions that are thought to improve the social welfare.
The bitcoin unmanaged fixed and inelastic supply provides a very different scenario with a trend deflation and no mechanism to absorb supply and demand shocks. It is often observed that bitcoin’s infinite divisibility would provide a solution to a money supply shrinking relatively to the economy, and that interest rates in equilibrium would adjust. Yet, it is not clear which would be the rate of growth in equilibrium. Also, the total lack of correction mechanism to absorb economic shocks would make the price level volatile relative to modern fiat currencies.
Andrade, P., J. Galí, H. Le Bihan, J. Matheron (2019) : “The optimal inflation target and the natural rate of interest”, Brookings Papers on Economic Activity
Akerlof, G, W Dickens and G Perry (1996): “The macroeconomics of low inflation”, Brookings Papers on Economic Activity, vol 1, pp 1–59.
Friedman, M and A Schwartz (1963): A Monetary History of the United States 1867-1960, Princeton University Press.
Klein, B (1975): “Our new monetary standard: the measurement and effects of price uncertainty, 1880–1973”, Economic Inquiry, April, pp 461–84.
Bordo, Michael, et al. “Deflation and Monetary Policy in a Historical Perspective: Remembering the Past or Being Condemned to Repeat It?” Economic Policy, vol. 20, no. 44, 2005, pp. 801–844.
M. Friedman (1969), The Optimum Quantity of Money, Macmillan
Chari, V, L Christiano and P Kehoe (1991): “Optimal fiscal and monetary policy: some recent results”, Journal of Money, Credit, and Banking, August, pp 519-39.
Schmitt-Grohé, S and M Uribe (2001): “Optimal fiscal and monetary policy under imperfect competition”, CEPR Discussion Paper, no 2688, February.
1 The Deflationary Economics of the Bitcoin Money Supply, https://www.skalex.io/deflationary-economics-bitcoin/.