Controlled supply

In a centralized economy, currency is issued by a central bank, at a rate that is supposed to match the growth of the amount of physical goods that are exchanged, so that these goods can be traded with stable prices. The money supply is controlled by a central bank through Open Market Operations. In the United States, the Fed sets the Federal Funds rate, and more recently, prints money electronically in a process called Quantitative Easing.

In a fully decentralized monetary system, there is no central authority that regulates the amount of currency incirculation. Instead, currency is created by the nodes of a peer-to-peer network. The Bitcoin generation algorithm defines, in advance, how currency will be created and at what rate. Any currency that is generated by a malicious user that does not follow the rules will be rejected by the network and thus is worthless.

Currency with Finite Supply

File:Total bitcoins over time graph.png

Number of bitcoins over time

Satoshi Nakamoto's answer to this problem has been to authorize the creation of a finite amount of Bitcoins. Bitcoins are created each time a user discovers a new block. The rate of block creation is set to be approximately constant over time. However, the number of Bitcoins generated per block is set to decrease geometrically, at a rate of approximately 50% every 4 years. The result is that the amount of Bitcoins created will never exceed 21 million.

21 million is the value at the asymptote for the formula used for generation. The number of bitcoins created starts at 50 bitcoins per block but then that rate drops by half after every 210,000 blocks. There is only speculation as to why the numbers 50 and 210,000 were chosen.

Inflation and Deflation

While the number of bitcoins in existence will never exceed 21 million, the money supply of bitcoins can greatly exceed 21 million due to Fractional-reserve Banking. So while the limited number of "hard" bitcoins will cause deflation in the long term due to positive non-zero reserve requirements, a fast increase in the money supply due to an adoption of Fractional-reserve banking can cause inflation in the medium term.

Worth noting are the Keynesian economic arguments against deflation; such that deflation tends to reduce profits and hence provides a dis-incentive for entrepreneurs to continue their operations. The Austrian school of thought adequately counters this theory, as deflation occurs in all stages of production and entrepreneurs also benefit from it. As a result, profit ratios tend to stay the same, only their magnitudes change. In other words, in a deflationary environment, goods and services decrease in price, but at the same time the cost for the production of these goods and services tend to decrease proportionally, effectively not affecting profits at all.

Price deflation encourages an increase in hoarding - hence savings - which in turn tends to lower interest rates and increase the incentive for entrepreneurs to invest in projects of longer term.

See also

• Milton Friedman interview, where he proposed to replace the central bank with a computer, and to fix the money supply growth at 4% annually
• Deflationary spiral