Many wonder about the benefits of using Bitcoin over our current fiat currency. And some of the first questions that may come to mind regarding Bitcoin are: Why should I use it? What’s wrong with my current fiat money? To answer these questions, we need to explore the fundamental differences between the two forms of money: fiat and Bitcoin. These differences are reflected in their corresponding inflationary and deflationary natures, which are tied to their respective supply mechanisms.
Fiat money
Governments with central banks issue fiat currency such as the US dollar or the Euro. One of the key features of fiat money is that its supply is not fixed and not limited; central banks can increase the money supply through a process called monetary expansion. Governments increase the supply by physically printing more banknotes or digitally creating additional money. Reasons for printing could be to stimulate economic growth or manage financial crises.
While monetary expansion can help stimulate economic growth during times of recession, it also leads to inflation. Inflation occurs when there is an increase in the overall price level of goods and services in an economy, eroding the purchasing power of the currency.
Bitcoin
Bitcoin, on the other hand, operates on a decentralized network of computer nodes and has a fixed supply limit of 21 million bitcoins. This means that unlike fiat currency, which can be created indefinitely, there will only ever be 21 million bitcoins in existence.
The fixed supply of Bitcoin makes it a deflationary currency. In a deflationary system, the value of the currency increases over time as long as the demand for it remains. This is so because the fixed supply means that as demand for bitcoin grows, its scarcity increases, leading to an increase in its value.
Inflation and deflation explained
Inflationary currency
We can compare inflationary fiat currencies to common collectible trading cards that are mass-produced and readily available. Just as the more common a card is, the lower its value, inflationary money loses value over time as more of it is produced and made available. Theoretically, this is offset by the created money being used to stimulate spending. As spending is increased, the currency is more sought after, therefore balancing out the inflation.
Deflationary currency
Deflationary money, Bitcoin in this case, can be likened to a rare holographic trading card. These cards were highly sought after in grade school, with students willing to trade almost anything to acquire them due to their rarity. Their exceptional value stemmed from their scarcity compared to other cards in the set. Similarly, Bitcoin's scarcity and fixed supply contribute to its increasing value over time. Like deflationary money, the value of the holographic card and Bitcoin grows as demand increases while their supply remains capped.
It is crucial to mention that Bitcoin is infinitely divisible into smaller units called satoshis. This divisibility means that even though there is a fixed supply limit, the ability to divide a bitcoin into smaller units ensures that there is no practical limit to the number of transactions that can occur. This feature not only increases the utility of Bitcoin but also contributes to its value proposition, as it allows for greater flexibility and usability in everyday transactions.
The ascending price of rarity
To further strengthen the analogy, we can say that a Wayne Gretzky rookie card will become more valuable over the years. Why is that? Since it is no longer being produced, its value increases as it becomes more rare. This is so because the proportion of cards compared to the amount of people that want them has made it so that there aren’t enough cards for all the willing buyers. In such cases, the buyers will pay an increasingly larger sum in order to get a card.
Challenges for bitcoin:
One of the major benefits of Bitcoin’s fixed supply is that it eliminates the risk of inflation. Because the supply of Bitcoin is limited and capped, its value is not subject to the same inflationary pressures as fiat currencies.
However, you might ask, what are the challenges? An example of one could be that if a large number of bitcoins are lost or destroyed, the overall supply of Bitcoin will decrease, potentially leading to deflation and volatility in its value. More precisely, the problem here could be that in a case where the equality of distribution is overly concentrated in one place, then a large sell off might lower the price.
Key takeaways:
Governments and central banks issue fiat currency, with a supply that they can increase at will through monetary expansion.
Monetary expansion can lead to inflation, eroding the purchasing power of the currency.
Bitcoin operates on a decentralized peer-to-peer network with a fixed supply limit of 21 million coins that no individual or organization can alter.
Bitcoin’s fixed supply makes it deflationary, with its value increasing over time as demand grows.
The fixed supply of Bitcoin eliminates the risk of inflation but makes it more prone to volatility.
Conclusion:
In conclusion, the fundamental difference between fiat money and Bitcoin lies in their supply mechanisms. Fiat has a flexible supply that central banks can increase or decrease, while Bitcoin has a fixed supply that cannot be changed.
Both forms of money have their advantages and disadvantages, and the choice between them ultimately depends on individual preferences and circumstances. For one to use bitcoin, they first have to understand what money is.
I’m grateful for the invention of Bitcoin because it challenged me to learn what money means and how it works. My goal here isn’t to give anyone financial advice, but to rather foster understanding, and I sincerely hope that I have helped you on your journey towards understanding money.
Useful links to my other posts and articles