Bitcoin’s price volatility has left many skeptics questioning the mathematical and economic basis for price movements as they search for a widespread justification for its valuation.
Due to its decentralized nature, bitcoin does not follow the monetary policy of governments and bitcoin is not backed by any underlying asset or government. this creates skepticism among investors and consumers who appreciate the signs of price stability a fiat currency enjoys from government policy and support.
Reading: What controls bitcoin price
bitcoin supply and demand
the price of bitcoin is determined in the same way as the value of the US dollar. dollar is determined: supply and demand. As a fiat currency, when the demand for bitcoin increases, the price increases. when the demand for bitcoin falls, the price falls.
On the supply side, bitcoin is a unique asset in that its new supply schedule is absolutely inelastic; it is completely immune to fluctuations in demand. When most goods, including fiat currency and gold, experience an increase in demand, producers react by increasing production and bringing prices back to equilibrium. when the demand for bitcoins increases, thanks to the difficulty adjustment, the production of new bitcoins does not increase.
stock to flow
The stock-to-flow (s2f) model is commonly used to analyze the impact of scarcity on the price of an asset. The stock-to-flow ratio is a number that indicates how many years it will take to produce the current stock at the current rate of production. Essentially, the stock-flow relationship is the inverse of an asset’s rate of inflation. According to the stock-to-flow model, a higher stock-to-flow ratio should produce a higher price.
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➤ learn more about the stock-to-flow model.
every four years, the bitcoin halving cuts the block subsidy in half, reducing the flow of new bitcoin into the market, increasing the stock-to-flow ratio and making bitcoin more even scarcer. If the stock-to-flow model is applied to bitcoin, this should trigger a spike in price, and indeed, each previous halving has caused a dramatic price spike in the months that followed. however, whether these price appreciations validate the stock-to-flow model remains a matter of much disagreement.
➤ Learn more about the bitcoin halving.
how does the scarcity of bitcoin influence the price?
Unlike fiat currency, there is a finite supply of bitcoin. there will only be 21 million bitcoins in circulation. new bitcoins are created at a fixed rate that decreases over time, causing demand to outstrip supply. this puts further upward pressure on the price.
In addition, the future monetary policy of bitcoin is known with absolute certainty, giving investors great confidence that inflation will be introduced or increased at a later date.
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By comparison, the creation and distribution of fiat currency is potentially infinite and unpredictable. Most central banks aim for a relatively low inflation rate, but these rates are subject to change by a small committee at any time, and the true rate of inflation for fiat currencies is almost impossible to measure.
Thanks to a finite supply and relatively small market cap, the price of bitcoin is also much more sensitive to changes in demand, resulting in higher price volatility.
➤ learn more about the impact of bitcoin’s finite supply.
inflation and deflation
Inflation occurs when the money supply or the velocity of money increases rapidly, causing prices to rise and reducing the value of the currency. bitcoin is deflationary due to its finite supply. the finite supply protects bitcoin from hyperinflation. A government’s ability to print an unlimited amount of currency has led to periods of hyperinflation that have reduced the value of many fiat currencies, including the German mark and the Zimbabwean dollar, to zero.
concerns about deflationary spirals are not well founded or supported by economists; supply and demand have always corrected for deflationary events in bitcoin and fiat currency. a finite supply also makes bitcoin a secure long-term store of value, comparable to and in some cases more advantageous than gold.
➤ learn more about why bitcoin has value.
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