Controlled supply

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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, mostly via its interest rates. Lowering the interest rates tends to increase the money supply ; raising them tends to decrease the money supply.

In a fully decentralized currency emission 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.

Finite supply and deflation

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.

A consequence of finite supply is that economic growth will cause price deflation : the value of Bitcoins will increase when more goods and services are traded using them.

However, there are economic arguments against deflation ; in particular, deflation tends to reward the people who save their coins instead of spending or investing them, and it does not favor trade and wealth redistribution.

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