How Is the Bitcoin Price Determined?
Table of Contents
- The Bitcoin price is determined through supply and demand.
- A finite supply of bitcoin mitigates inflation and deflation risks.
- The stock-to-flow model uses the current circulation of bitcoin and the rate of production to measure the effect of scarcity on the BTC price.
The price volatility of Bitcoin has left many skeptics questioning the mathematical and economic basis of price movements while searching for a generalized justification of its valuation.
Because of its decentralized nature, Bitcoin doesn’t 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 price stability signals a fiat currency enjoys from government policy and support.
Supply and Demand for Bitcoin
The price of Bitcoin is determined in the same way that the value of the U.S. dollar is determined: supply and demand. Like fiat currency, when the demand for bitcoin increases, the price increases. When 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 a rise in demand, producers react by increasing production and returning prices to an equilibrium. When demand for bitcoin rises, thanks to the difficulty adjustment, production of new bitcoin does not rise.
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 production rate. Essentially, the stock-to-flow ratio is the inverse of the inflation rate of an asset. According to the stock-to-flow model, a higher stock-to-flow ratio should yield a higher price.
Every four years, the Bitcoin halving cuts the block subsidy in half, reducing the flow of new bitcoin into the market, thereby increasing the stock-to-flow ratio and making Bitcoin even more scarce. If the stock-to-flow model is applied to Bitcoin, this should trigger a rise in price, and indeed, each past halving has triggered a dramatic price rise in the following months. However, whether these price appreciations validate the stock-to-flow model is still a topic of much disagreement.
How does the finite supply of bitcoin influence price?
Unlike with fiat currency, there is a finite supply of bitcoin. There will only ever be 21 million bitcoin in circulation. New bitcoin are created at a fixed rate that decreases overtime, which causes demand to outpace supply. This puts further upward pressure on the price.
Additionally, Bitcoin’s future monetary policy is known absolutely, giving investors great confidence that inflation will be introduced or increased at a later date.
Comparatively, the creation and distribution of fiat currency is potentially infinite and unpredictable. Most central banks target a relatively low inflation rate, but these rates are subject to change by a small committee at any time, and the true inflation rate of fiat currencies is nearly impossible to measure.
Thanks to a finite supply and a relatively small market cap, the price of Bitcoin is also much more sensitive to changes in demand, resulting in increased price volatility.
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 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 caused periods of hyperinflation that have driven the value of many fiat currencies, including the German Mark and Zimbabwean dollar, down to zero.
Concerns over deflationary spirals are not well-founded or supported by economists; supply and demand have always corrected deflationary events in bitcoin and fiat currency. A finite supply also makes Bitcoin a secure long-term store of value, comparable and in some cases more advantageous than gold.