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 the central bank, effectively manipulating interest rates. Interest rates are then not representative of savings anymore, which are the basis for production in the economy. This creates a boom that inevitably leads to a bust when entrepreneurs realize they cannot finish the projects they started due to the mis-allocation of resources created by the boom.
In a fully decentralized monetary system, there is no central authority that regulates the amount of currency in circulation. Instead, currency is created by the nodes of a peer-to-peer network. It is therefore necessary to define in advance how currency will be created, and to build the creation rules into the protocol used by the nodes of the network.
Currency with Finite Supply
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[1].
While the number of bitcoins in existence will never exceed 21 million, it must be understood that 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.
Controlled inflation
There is no theoretical reason why a peer-to-peer and decentralized currency emission system should use a limited amount of currency. Instead, the limited money supply of Bitcoin seems to be a choice of its creator. It is not a limitation of peer-to-peer currencies.
It would be possible to create a variant of Bitcoin with a controlled inflation rate. Instead of geometrically decreasing the amount of coins attributed to new blocks, this amount would be increased each year, at a predefined rate.
For example, if the initial value of a block is 50 coins, and if the increase rate is 2%, then the money supply would increase as follows:
| year | value of new blocks | (money supply)/(new blocks per year) | money supply increase (%) |
| 0 | 50.00 | 50.00 | - |
| 1 | 51.00 | 101.00 | 102.00% |
| 2 | 52.02 | 153.02 | 51.50% |
| 3 | 53.06 | 206.08 | 34.68% |
| ... | ... | ... | ... |
| 10 | 60.95 | 608.43 | 11.13% |
| 100 | 362.23 | 15973.84 | 2.32% |
As the money supply grows, its rate of increase will tend towards the rate used to increase the value of new blocks (2% in this example). The increase of the money supply is not decided by a central authority or government; instead it is known in advance, and economic agents can integrate it to their expectations.
Choice of the increase rate
It is important to note that the choice of a predefined increase rate does not guarantee that deflation will never occur; if the economy grows faster than the money supply, price deflation might still be observed.
In theory, it would be possible to create several currencies with various increase rates, and to let markets decide their relative values ; in practice, however, having to deal with multiple currencies might be confusing and unpractical.
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