Understanding Price Inflation and Deflation in Crypto

Let’s chat about the differences between these two concepts and the theories behind them. I’m eager to hear what everyone thinks! I’ve seen a lot of confusion around here about inflation and deflation, so I figured we could use a dedicated thread to clear things up. This comes from a convo in Wall Observer. Price Deflation is a term you often hear in the Bitcoin space. It refers to the decreasing prices of goods and services as the value of Bitcoin rises. On the flip side, Price Inflation means the prices of goods and services are increasing because the value of Bitcoin is dropping. So with Price Inflation or Deflation, there's this inverse relationship between price and value when it comes to goods, services, and Bitcoin. For example, if Bitcoin's price increases from $10 to $20, then the prices of goods/services would drop from 20BTC to 10BTC. Conversely, if BTC drops from $20 to $10, those same goods/services would go from costing 10BTC to 20BTC! What makes Bitcoin’s price fluctuate? The ups and downs are driven by the exchange rate or market price, which buyers and sellers determine. These traders swap Bitcoin with various currencies, including gold. The USD is the most common. They set the price every time they execute buy or sell orders. I’ll touch on what really causes these price swings later.

An excellent post that I'll sticky so people can learn from.

http://dictionary.reference.com/browse/inflation?s=t noun 1. Economics . a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency ( opposed to deflation ). 2. the act of inflating. 3. the state of being inflated. Dictionary.com does a pretty good job of defining what inflation actually means, I should point out that I suspect a lot of people are following what they learned in school history which is a form of neo-keynesian economics which I of course think is a load of bullshit, people who believe in the neo-keynesian field are often guilty of outright making up words and ignoring mathematics to try and confuse people, look at words like Quantitative Easing as an example. Be suspicious of everything, question everything.

Pulling in some quotes that got the discussion started (each has a link to the original): thoughtfan, we're both talking about supply and demand. I ascribe the increase in demand to both exchanges and mining. If mining 25 BTC was solely an increase in supply, the value of BTC would go down. (This is what I understood your argument to be.) I feel that mining increases the value of each BTC because it reinforces "the way BTC works": There will come a point when mining isn't profitable and the network could be vulnerable to attack. At that point, we should have this discussion again. Right now, miners get paid to invest in BTC: they're investing hardware, time, and electricity but the effect is still an increase in the demand for BTC. Right now, mining resembles interest payments: leave your resources in the BTC network and you get rewarded, doubly so when BTC appreciates against other currencies. notme pointed out that mining must be strong enough to convincingly guarantee against attack. I'm taking it one step further and saying that (for the time being) mining is a lower-risk way to get BTC, exchanging hardware, time, and electricity for BTC. The reward for mining has been high enough that more effort is spent mining than speculating. Specifically a miner must put their money in hardware, the risk being that the hardware will lose some or all of its value before the miner stops mining. A miner must also take the time to set up, troubleshoot, and maintain their mining equipment, losing the opportunity cost of their time. I hope this explanation makes sense: the miner is investing – operating equipment instead of exchanging USD (or some other currency) for BTC. Miners want BTC, so they make the investment to get it. Some miners may be solely looking to dump their BTC back into fiat for a (fiat) profit, but that seems to be the exception, not the rule. This is not just because of the trending value of BTC, or the network hash rate would be more closely correlated to the value of BTC. If BTC crashed low enough things might change, but at present miners do it for the BTC. That's how I think mining increases BTC's value – "the way BTC works for the time being." - - - I believe mining is lower risk than exchanging because the rewards are predictable. It's still possible to be stupid and do something like CPU mining, which gets you practically 0 reward and costs you a lot in terms of electricity etc. But assuming miners are rational and capable of evaluating the cost/benefit, and assuming the ASIC vendors get their act together so that supply and demand for ASIC mining hardware evens out, then mining is lower risk because of the fixed startup costs and predictable exponentially decreasing returns. It's possible to lose money on mining, but the variables (difficulty, block reward, network hash rate, mining pool fees, PPS vs PPLNS vs DGM vs POT etc.) are all in the open. The variables that affect you when you speculate on the exchanges are mostly hidden. The ASIC vendors right now are creating huge pent-up demand which may even be pushing the price of BTC up as some sort of bubble. Ordinarily a rational actor would see this much demand and respond by cashing in on it and selling ASICs until the demand drops back down. Apparently, successfully shipping an ASIC is so hard that there's a sort of speed bump happening right now. Finally, back to the original discussion, market cap may be an indicator which we can study to understand supply and demand. However, it is not a primary cause of supply and demand or BTC value. If market cap measured in USD was a primary cause of BTC value, then we should all view BTC as a bank to temporarily deposit USD and maybe collect some interest (making BTC a ponzi scheme). The appeal of having some BTC is not at all the market cap measured in USD. Without speaking for everyone, I believe BTC's appeal and inherent value is secure storage of value coupled with convenient exchange of value. Looking at the market cap is still informative though. The value of a USD $1 will decrease because USD suffers continuous inflation. The value of 1 BTC will increase for the time being because demand for BTC is increasing faster than supply. And after most of the BTC have been mined, the value of 1 BTC will increase because of the deflationary nature of BTC. But we should definitely have this discussion again at that point, to see what it means for the miners.

As mentioned in the original post, a large part of Bitcoin's positive value (which increases the exchange rate of BTC) is the DEMAND for Bitcoin, via the physical manifestation of that ideological value through trade (in this case, BUYING BTC). However, this is not the end of the story, and you bring up this great philosophical question which I am delighted to dive into! So now we must travel deeper into this rabbit hole, as we ask, what creates this demand!? Why do people find Bitcoin valuable enough to trade anything for it?! Here is my response to this question in a related discussion at What is bitcoin backed by? My favorite answers Therefore, we can certainly add to our list that "Mining increases the value of each BTC because it reinforces 'the way BTC works'" and its "secure storage of value coupled with convenient exchange of value."  Personally, I agree with you on both accounts and believe those to be some of the more important and valuable aspects of Bitcoin. As for the comment regarding Market Capitalization: after this post, I think you have a better understanding of where I was coming from when I posted it, so certainly not arguing with you there!   I am actually working on creating an inflation-adjusted BTC/USD chart at the moment, just to have a solid visual of that here. Though, honestly, you could just look at a Bitcoin chart priced in gold and you would have another somewhat-similar visual. Like the Market Cap chart, this is just another representation of Bitcoin's value, yes, but I do think they are important when attempting to predict market trends, as you know. A chart of that can be found at a fellow Bitcoin users blog: http://pricedingold.com/ It's a cool blog. He charts pretty much everything in terms of gold. Lots of great data!!

thanks man

I'm not sure if it's just me but I had a hard time understanding the underlined. Is that redundant? from itself and other currencies? Anyways, with the ASICs coming out soon, what do you think the value of bitcoin will do for the the first couple of months? I feel like it will start to drop rather rapidly as people are trying to get their hands on more USD to compensate for their expenses. Then they would start to keep the BTC and the difficulty would rise so it would go back up?

Sorry for the lack of specifics there! My point is: Price inflation is not only derived from the market price of whatever it is you're exchanging a currency for, but it is also derived from the value of the currency 'itself', meaning the rate of monetary inflation along with supply and demand of that currency. In other words, prices of good/services (price inflation/deflation) are reflective of the exchange rate due to FX trading and the Bitcoin generation rate due to mining (monetary inflation). So, 'something' worth BTC1 can 'deflate' in price to BTC0.5 if any or all of these market forces apply to it: 1. The currency exchange rate of whatever that 'something' is usually traded in doubles (BTC/USD increases from $1 to $2 per BTC) 2. That 'something' becomes cheaper to make (greater supply) or needs to stay competitive in price (weaker demand) Keeping in mind that the currency exchange rate or PRICE of Bitcoin (force 1), is determined by the value of the currency, which is the SUPPLY and DEMAND and so on and so forth as explained in the OP... Price inflation would be the opposite. Let me know if that makes more sense lol

After just bashing the "keynesian" definition of inflation, you segue right into your own piss-poor definition. Money supply inflation is when the total money supply increases. No more, no less. It does not necessarily mean a change in the value, because if the money supply increases at the exact same rate as the increase in demand, there is no change in value. First you say it will never occur, then you say well it could and does happen. The set decrease in the generation rate would be called "money supply disinflation" if you want to, god forbid, use another modern economics term. And exchanging money for services at a faster rate than the generation rate has no deflationary effect, only the demand for currency itself affects its value. If the velocity of money increases to account for increasing exchange, there need not be any change in value. Again, exchanging does not increase value, demand for more currency will.

Here come the Keynesians...   Money Supply Inflation refers to the devaluation of a currency due to the increase of the Money supply. Whereas, an increase in the Money Supply is exactly that, "when the total money supply increases". The former is an effect of the latter, and I wasn't referring to the latter. Now to consequently address the demand argument... In any real economy, there is no guarantee that demand exists (maybe in the keynesian paradise, but that's about it). However, there is a guarantee that the Money Supply will increase. Money Supply Inflation (or inflation due to an increase in the money supply) exists regardless of demand, contributing to the devaluation of the currency. Demand simply helps to stabilize or increase the value and price. Sure, they can offset when they're equal, but that doesn't mean inflation due to an increase in the Money Supply doesn't exist. So I will argue that Money Supply Inflation does mean a change in the value. Keyword "essentially". It happens, sure, but on a scale so small that it's negligible. The details here aren't a huge issue, I'll edit that to be more specific. Though, I think most other people get it...   That statement was regarding the exchange of FX for BTC ie demand for BTC that is greater, not faster. That one can be clarified, as well. You're right, demand can increase the value of a currency... but someone has to have a supply for that demand... and god forbid the two got together to have an "exchange" *gasp*! They would have unknowingly increased the value of both items!   So yes exchanging does increase value, and it doesn't have to be between currencies. When the first pizza was bought with 10,000 Bitcoins, they had (maybe unknowingly) set a value of Bitcoins at around $10/10,000 BTC, or 10,000BTC/pizza. This would go on for a while until the value is where we are today. Sure, I could edit some things to be more specific. Though, I have a feeling that won't satisfy your issues with the first argument...

More like, someone who actually understands economics. Unsurprising based on your other definitions if that's your definition of keynesian. Do you know what the word "inflate" means? Do you not realize that it means the same thing as increase? You are doing the exact same thing you accuse keynesians of doing. "THIS is what I mean, not THAT." I'm sorry but that makes you look like a total tool. I assume you mean demand for new money, and I never said there was guarantee for new demand, only that if the supply is increasing with demand, there is not necessarily any change in value. It is very basic supply and demand which also applies to currency. Here you go again disagreeing with yourself. If you are going to create your own definitions for things, you ought to be very careful with the words you choose. You cannot say "A does not always follow B" then say "A follows B" as your statement of logic. Again, just pointing out that if you are making definitions, you have to be careful so as not to cause the same problems you blame keynesians for. And, if you want to get technical with real-world economic definitions (unimportant, I know), money supply inflation/deflation generally refer to currency in circulation. How, when, where, or why currency enters or leaves circulation is irrelevant to that definition. It is very relevant to the discussion, though, which is why you need to be specific and precise when talking about economic effects and their causes. Not making things even more hazy with wishy-washy redefinitions. But you are making statements about things that have little to do with each other, and seriously confusing terms and/or economic cause and effect. "That being said, there is a SET DECREASE in the generation rate of BTC, so you have sort of a "deflationary effect" in the value, as long as more exchange occurs for BTC at a rate which is faster than that set generation rate." Read the bold part alone and the cause and (incorrect) effect are already there. The generation rate has nothing to do with the definition of money supply deflation. If you mention value anywhere in money supply definitions, you are defining them incorrectly, because the supply cares not for its value. Value comes from the combination of supply and demand. You are not defining money-value deflation (whoops, that's price), so why then do you talk about exchange or value. You are making your definitions quite unclear, the exact opposite of your intended premise. No, it doesn't. If money is spent faster (increase V), without an increase in total goods and services in the economy (Q), the price level (P) actually goes up, a/k/a price inflation. Greater or faster, it does not matter, increasing the amount of money spent (exchanged for goods and services) over a set period of time can increase prices. *gasp* Believe it or not, price inflation can happen without an increase in the money supply. Now if more goods and services become available for bitcoin, thus increasing its desirability, then the demand for bitcoins will likely increase, thus causing price deflation as the supply is inelastic. It is NOT the exchange itself that causes (price) deflation. And if you want to redefine the word "exchange" to mean specifically "exchanging for other currency", be my guest, I'm sure it will be a useful add to the bitcoinomist's dictionary. But it still doesn't cause price deflation unless people want BTC more than fiat. Which, unless you are a tool, is not guaranteed.

Since we're both very excited about this, and to restrain our words from moving too far from the point, I think we should address one issue at a time. I will start with a definition of inflation that I agree with: in·fla·tion   Noun The action of inflating something or the condition of being inflated (This is the definition not related to economics)A general increase in prices and fall in the purchasing value of money (This definition is related to economics) My interpretation from the above definition related to economics: 1. Price Inflation refers to the "general increase in prices" part of that definition 2. Money Supply Inflation refers to the "fall in the purchasing value of money" part of that definition Therefore, I can not agree that inflation "means the same thing as increase", as it conflicts with the "fall in the purchasing value of money" part of that definition. Note: this is not an argument of what the "general increase in prices" or "fall in the purchasing value of money" means. We can get to that once your interpretation of the word inflation is understood.

Didn't we already go over this? Money supply inflation means there is more money in the money supply than previously. Supply on its own has nothing to do with value (in a vacuum, admittedly), it is only a quantity; only when it is combined with demand can you determine a value or price. So you are using the "keynesian" economic definition to make an argument? I thought this thread was about avoiding that. The gist of what people who dislike the contemporary meaning of inflation is that it is talking about an effect rather than a cause, something you have unfortunately not grasped in your posts, and really have fallen into the very trap for which the term is disliked. I am capable and willing to use my brain to derive the meaning of the word inflation from the context. Around here, that is generally frowned upon because of something a monetarist once said that was misattributed to an austrian.

Please, the definition of inflation is not that controversial of a topic! I have the feeling somebody is getting trolled here.

You've been around here for all of 2 months and feel qualified to say that? You should do some more reading.

That's the thing though, you guys are getting trolled, by those damn neo-keynesians

"Keynesian economic theory proposes that changes in money supply do not directly affect prices, and that visible inflation is the result of pressures in the economy expressing themselves in prices." -Keynesian view of inflation Lethn, get out the way man! Let the trolls economists have their serious discussion, alright?

Carefully read what I wrote and try again. I am trying to neutrally define a term without any accompanying effect, not deny an effect happening. From your OP on money supply deflation: "so you have sort of a "deflationary effect" in the value, as long as more exchange occurs for BTC at a rate which is faster than that set generation rate." You are doing the same thing as the keynesian definition but to the opposite effect. *I* am not claiming that money supply inflation has an effect one way or the other. *I* am defining a term without judgment or predilection. Before you can determine a value or a change in value, you need to know the demand or change in demand. The terms "money supply inflation" or "money supply deflation", in the clearest sense of the words, can only mean an increase or decrease in the money supply. That's the whole point of writing "money supply" in front of the words. Unfortunately and less clearly, "money supply" can mean the total number of individual undivided units (including the money multiplier for most measurements), or it can mean those units in circulation (this one, more often than not). Either way, it is not a measurement of value. An example of the "right" way to use these terms: The Fed expanded the money supply by 3.6% last year. That money supply inflation is believed to have caused most of the 3.1% price inflation over the same time frame, leaving 0.5% to real growth. See how clear and direct that statement was? That's because cause and effect are clearly portrayed, and they can also be clearly argued for or against if necessary. The sentence asks, "do you have better data to refute this claim?" not "what kind of fuzzy logic can you come up with to confuse the average joe?" like what happens when the words inflation and deflation are tossed around naked. To top this off: there are plenty of periods that actually exist in history where you could make this statement "The fed expanded the money supply by x% last year. That money supply inflation is believed to helped encourage the x+1% growth over the same period." Maybe they're not as common, maybe it's a sign of a bubble, but the fact remains that you cannot say for certain that the same cause always has the same effect. There are WAY TOO MANY VARIABLES. In the same vein, you can't be sure the same effect has the same cause. So the cause has to be separate, without bias and analyzed on its own merit. By separating out money supply inflation/deflation vs. price inflation/deflation, your goal should be to clearly and simply define those terms--then use them to make the statement that you want to make (and make an attempt at being unbiased--do not make guarantees), not make your statement within the definitions. It is dishonest otherwise, but perhaps just misguided.

Greetings everyone, ...little confession here, I think I may be a Keynesian ... but I have thick skin so you can beat me up.  While I despise them, I see the genius of the Federal Reserve system.  I also believe that the federal reserve system is like a dinosaur now as we stand on the brink of a crypto-currency era. Every economy needs two types of money: one to store value, and the other for daily trade.  Clearly for today's world we use fiat currency for daily trade and a host of assets to store value: gold, real estate, bitcoin, etc.    Bitcoin is designed to store value and/or appreciate value.  Some have mentioned above how the rate of manifestation of Bitcoins is growing so much slower than the adoption and demand for Bitcoin, and is the situation that is leading to Bitcoin's rapid appreciation in value.  That appreciation affects human behavior and so we hoard Bitcoin rather than trade freely with it.   This is not a weakness of Bitcoin, simply the way it is designed.  It's purpose now, whether we all like it or not, is "value storage" not "trade facilitator". Agree or disagree, but there is a huge opportunity in the crypto-currency world right at this moment.  We need a cryto-currency that is designed for daily trade.  It can be just as fair and open and free and anonymous as Bitcoin, but it does need to incorporate some of the, I dare say, "Keynesian" design attributes of our common fiat currencies.  With crypto-currency, we have the ability to take the art out of the FED chairman's job and solve the problems of currency/price management with computer code. We need a cryto-currency that people won't tend to hoard.  It needs to hold it's value day to day, but generally decrease in value over the long term in a similar way as fiat currency.  The job of the FED can be accomplished with an open formula for all to see so that it is fair and people know what they are getting.  Money supply can be controlled in real time in response to several factors like "money velocity", "adoption rate", and whatever other economic factors that must be accounted for to keep prices relatively stable, yet slowly inflating. Adding to the money supply is easy, but there is a need for a mechanism to pull down the money supply when economic conditions dictate.  So, we would need a reserve bank of sorts to store a valuable asset (like Bitcoin) and then sell off that asset when needed as a means of pulling the trading crypto-currency out of circulation when needed. Does anyone have other ideas for actively managing the money supply of our new crypto-currency world?  Could we manage money supply in a decentralized way?  Could we make every client their own little central bank?

There's genius in stealing?