Source: Anony, BTCStudy

One of the criticisms of Bitcoin that has been raised by people is that "Bitcoin's supply will not increase after reaching its limit, and this inflexible supply is not suitable as a currency." This viewpoint is unique because it targets Bitcoin's value proposition - that Bitcoin is a currency with a limited supply, which is precisely why many people love it and believe it has value.

Furthermore, this viewpoint will put forward two arguments: (1) In some cases (especially when economic activity enters a downturn), increasing the amount of currency can stimulate economic activity and restore vitality to the economy; similarly, in some cases, reducing the amount of currency can be beneficial; (2) People's daily lives are almost inevitably prone to forgetting or losing currency, and this effect accumulates over the long term, which will continuously reduce the amount of currency that can circulate and create a shortage of currency, which is not conducive to market trade [1].

I believe that these arguments are not tenable. However, in order to analyze these viewpoints, we must first understand the currency itself - essentially, currency is also a commodity with its own market and price.

Currency Market and Prices

In general, there are two prices for currency: purchasing power and interest rate.

Purchasing power refers to the ratio of currency exchanged for other goods, and some people use "price level" to refer to it. How much can a certain amount of currency units (such as 100 US dollars/yen/grams of gold) buy? This is the purchasing power of the currency.

Interest rates refer to the exchange ratio of cash at different time periods for the same currency. How much is today's 100 yuan worth a year from now? When you lend someone 100 yuan, how much interest do you require? In such borrowing and lending scenarios, the exchange of cash (or cash equivalents) at different time periods (now and one year later) will always involve interest. The reason for this is simple: cash itself is valuable, and "a bird in the hand is worth two in the bush." In order to exchange the currency in people's hands, a certain cost must be paid.

There is also a view that there are four types of prices for currency, the other two being "parity" and "exchange rate" [2]. The former refers to the exchange ratio between the same but different types of currency, such as the exchange ratio between cash and bank deposits, which generally needs to be 1:1. The latter refers to the exchange ratio between different types of currency. These concepts are useful in certain scenarios, but we don't need to delve into them here for the time being.

The purchasing power and interest rates, just like the prices of other commodities, are: (1) generated in market transactions; (2) regional; (3) constantly changing.

The purchasing power of currency arises in the comparison, negotiation, and transaction of prices among consumers; similarly, the interest rate of currency is constantly matched between the supply and demand sides of currency savings. The purchasing power of currency also has regional differences, and the same amount of currency units may be able to buy different quantities and qualities of things in different places. In real life, the real-time and continuous changes of these two prices are not observed because price adjustments also require resources and time, which does not mean that they will never change.

Like the prices of other goods, the price of currency is also to coordinate the distribution of currency among different groups of people and different time periods, in order to meet people's various needs: using cash to purchase goods and services, obtaining necessities of life, saving money to support long-term plans, saving money to hedge risks, and meeting turnover needs. In the past, in the era of metallic currency, the price of currency could also guide the production of new currency.

So, what impact does changes in the quantity of currency have on the price of currency? Let's start with purchasing power.

Fisher Equation

We start with a mathematical formula that is often cited in the field of monetary economics:

Here, M represents the quantity of money; V represents the velocity of money circulation; P represents the price level (or purchasing power level); T represents the quantity of goods traded. This equation must hold true because it expresses a "tautology" (also known as "redundancy") - it describes two aspects of the same process (market transactions).

The expression on the right side of the equation represents the trading volume in the market. "Price level" does not actually exist as a tangible concept, but rather an abstract one that is derived by dividing the market trading volume by the quantity of goods. Therefore, multiplying it by the quantity of goods gives us the market trading volume. On the other hand, the left side of the equation represents the other side of the trading process - regardless of the trading volume, it means that people have exchanged the same amount of currency units. However, the currency does not disappear after the transaction, and people will continue to circulate it, so we need to multiply it by a velocity of circulation.

Economists often use this formula to illustrate the consequences of an increase in "monetary quantity" - let's not worry about the strict definition of this concept, what counts as money and what doesn't - assuming that V and T remain unchanged, the result is an increase in P, or a decrease in the purchasing power of money.

This kind of argument is very useful - it shows us that if something that causes a change in the quantity of money does not cause an inverse change in the velocity of money circulation and the quantity of goods exchanged, then an increase in the quantity of money will cause a decrease in the purchasing power of money. However, it is not perfect - we cannot guarantee that these two factors will not necessarily change in the opposite direction.

Next, we will learn about another theory that is older but actually more profound.

Kantillon Effect

Kantillon [3] was a merchant who lived in the early 18th century. He keenly observed a phenomenon: when currency is increased, not everyone receives the newly issued currency at the same time. This also means that not everyone is aware that the value of the currency is decreasing at the same time. The newly generated currency will ripple out like a stone thrown into water, gradually spreading outward with the economic activities of those who first received the currency, until it reaches everyone. In this process, the earlier one receives the currency, the greater benefits they can get from the new currency, because they can spend the currency based on its relatively undepreciated purchasing power. On the other hand, those who receive the new currency later will suffer losses. This situation is called the "Cantillon effect".

Kantillon's observation is more profound than Fisher's equation, because it realizes that the economy has structure and people carry out their activities over a period of time. Increasing the money supply will not distribute new money equally among all people according to the existing amount of money, nor will it instantly devalue all the money in people's hands. Instead, it spreads outward along the structure of the economy and becomes clearer as it spreads. (Do you remember what we said above? The purchasing power of money also varies by region.)

This is the truth about currency issuance and purchasing power depreciation - no matter who claims that there are benefits to this process, these benefits will not be equally distributed to everyone. Some people may get a lot, while others may get nothing - it will obviously become a source of polarization between the rich and the poor.

In the era of metal currency, mining metals came at a cost, and the scale and profit of currency production enterprises were also constrained by the market itself. If the profit margin of manufacturing currency is higher than that of other industries, people and capital from other industries will be attracted to the currency manufacturing industry, accelerating the production of currency (devaluation) while reducing the profit margin of the industry. This process controls the amount of currency issuance. However, in the era of paper currency, this mechanism disappeared. The lack of market constraints means that the quantity of paper currency depends entirely on the mood of the currency issuing authorities, and almost any amount can be issued. This is why the phenomenon of excessive issuance of currency leading to the collapse of purchasing power ("hyperinflation") observed on paper currency (in China during the Yuan Dynasty, the Nationalist Party era, as well as in present-day Zimbabwe and Venezuela) far exceeds that of metal currency.

"Malignant inflation" is a very clever term, which seems to imply that some inflation [4] is a good thing. However, this statement is actually akin to saying that poison can quench thirst.

Next, we need to consider the impact of changes in the quantity of currency on another price of currency - interest rates - and its market.

Interest Rates, Savings, and Production

Interest rates are used to communicate between the suppliers (people with surplus cash who are willing to lend money) and consumers in the lending market. It should be noted that while the suppliers and demanders may have different evaluations of the utility of money, the nature of these utilities is the same for both parties: money can be exchanged for other goods in the market. For suppliers, lending cash means losing the benefits that cash can bring to them - the ability to fight against risks; for consumers, it means gaining the benefits of cash - the ability to immediately obtain the desired goods and services, such as medical care, production equipment, and debt repayment ability.

Here, we are concerned with two phenomena: the separation of "nominal interest rates" and "real interest rates", and the relationship between interest rates and production.

In the contract between the lender and borrower, they only specify one interest rate. Translated, it means: "I am lending you 100 now, and in one year, you should return me 100 * (1 + i) units." This interest rate i is known as the "nominal interest rate". However, the "real interest rate" that the lender receives/borrower bears should be (1 + i) * (1 + d) - 1, where d refers to the change in currency purchasing power. This is because the borrower's repayment difficulty is not only determined by the nominal interest rate they agreed upon, but also by the change in currency purchasing power itself - if the currency is becoming harder to obtain (currency purchasing power is rising, d > 0), the borrower's burden will be greater than nominal; if the currency is becoming easier to obtain, the borrower's burden will be reduced.

Undoubtedly, when negotiating contracts, both the lender and the borrower will have their own estimates of d (which can only be estimated because it has not yet become a reality). This estimate will also be reflected in i. If the lender expects the purchasing power of the currency to decline, they will naturally increase the nominal interest rate to compensate themselves. But estimation is just estimation - if the actual performance of d deviates from the expectations of both parties during the loan period, the benefits obtained from this contract will also deviate from their expectations.

We have already mentioned that there are two forces that affect the value of d in summary: (1) changes in the quantity of currency; (2) changes in supply conditions. Technological progress, improvement of infrastructure, accumulation of knowledge, and improvement of international trade relations will all increase production capacity, make goods cheaper, and increase the purchasing power of currency. Conversely, the deterioration of these conditions will also lead to a decrease in the purchasing power of currency.

And the increase in the quantity of currency will cause the purchasing power of the currency to decrease, which will reduce the profits of creditors. That's why we often say that increasing the issuance of currency is not good for creditors, and why kings in history were so fond of diluting the purity of metallic currency - increasing the issuance of currency will also dilute their debt burden. Conversely, it will increase the profits of creditors, but it is not good for debtors.

But no matter what, the greater uncertainty brought by d means greater resistance in the lending market. This is why Milton Friedman advocates a fixed rate of monetary policy. Regularly increasing the money supply can minimize the impact of monetary factors on purchasing power and reduce resistance in the lending market. The same benefits apply to a currency with inelastic supply.

On the other hand, interest rates also affect the expansion of production activities. We use an example to illustrate.

Jia is an entrepreneur who found that he can borrow X units of currency at an interest rate of i in the name of i, with a loan term of Y. During the Y period, he can use X amount of currency to increase production equipment and receive currency income Z at maturity, so that X * (1 - c) ^ Y + Z > X * (1 + i) ^ Y (where c is the depreciation rate of production equipment). If his income during the loan period is sufficient to cover the depreciation of new equipment and the interest on the loan, he will borrow the amount and convert it into production equipment to increase production.

This example can serve as a general case study of the production process for capital goods (a combination of all resources specifically used for the production of certain products). When Party A uses their own saved money, they can be considered their own lender - the benefits of increasing production must outweigh the benefits of saving money in order to attract them to execute the production plan.

Quantity of Currency

Previously, we left an unresolved question: what is the quantity of currency? Assuming we are using a paper currency, is the quantity of units of issued paper currency the quantity of this currency?

Or, to put it another way, our question is: what form of currency quantity changes will result in the aforementioned effect (decrease in purchasing power of currency)?

This is not a problem that we have only raised today, nor is it a problem that arose only after the appearance of the Fisher equation - after all, people have known for a long time that an increase in the quantity of money will lead to its depreciation.

In 19th century England, people lived in an era where gold was used as currency. However, at the same time, major banks also issued their own banknotes (paper money) that could be used to redeem the gold stored in the bank. Like us, people also debated: what exactly constitutes as currency? Is gold the only form of currency? Does paper money, which is easier to circulate and can be used to redeem gold, not count as currency?

On the one hand, discussing this issue is driven by policy interests: if these paper currencies are considered as money, should the law also regulate their issuance [5]? On the other hand, it is also a requirement for academic progress.

Today we learned that, theoretically speaking, the importance of the criteria for determining currency is not in the currency itself, but in other things related to it: what we really want to know is whether the changes in the quantity of their derivative forms, in addition to the physical cash forms we are familiar with - metal coins and paper money with central bank stamps - will have similar effects to changes in cash quantity.

The answer is, of course. Today, no one would deny that deposits held in banks, which can be immediately circulated, are also currency; time deposits and money market funds that cannot be immediately circulated are also considered currency, although their level (or monetary nature) is different. There may not necessarily be 100% physical currency support behind the deposits held in banks; under a non-100% reserve system, banks only need to provide a certain proportion of cash as a guarantee that matches the amount of the deposit; when the bank (within the legal limit) decides to reduce the amount of the guarantee, it will cause an increase in deposits, which also has the effect of increasing the amount of currency, but to a different degree.

Now, we can return to the argument against non-elastic currency.

Stimulate production or stimulate mistakes

People who support using currency to "regulate" the economy do not deny that changes in the quantity of currency will affect the purchasing power and interest rates of the currency. On the contrary, they believe that this impact can be used to their advantage. For example, when the economy enters a downturn, increasing the issuance of currency can cause the price of goods to rise (because the purchasing power of the currency has decreased, so the nominal price of goods has risen), and this price increase will make people think it is profitable, so people will resume or increase production. At the same time, when the expansion of currency causes nominal interest rates to fall, people will also find that the cost of their risky activities has decreased, which will naturally attract them to increase production.

These two statements sound very attractive, and even some observable phenomena may be consistent with them - but in fact, they are not tenable.

Take the former as an example. In fact, this means that for these producers, the accounting profitability depends entirely on the depreciating currency. That is, if the currency does not depreciate, they cannot observe that the monetary return on production activities is greater than the monetary value of their own resource inputs. When they calculate their profits at the end of the period, if they take into account the purchasing power depreciation of the currency itself, they may find that they not only have no profit, but actually have losses, or in other words, it is better not to do it. Here, the depreciating currency actually creates an illusion, that is, it adds information noise to market activities and hinders people from forming new production-consumption structures under new conditions. The so-called economic downturn is actually people spontaneously moving towards this new structure.

It is also true to lower the nominal interest rate of the market by increasing the currency through currency issuance. In the legal currency system, increasing the amount of currency becomes easy, thus lowering the nominal interest rate of borrowing also becomes easy. However, people forget that it is the savings of real resources, not the quantity of money, that can support production expansion. During the formation of capital goods, these semi-finished products actually cannot bring any benefits to people, and it also requires people to continuously add resources to become something truly productive. The artificially lowered nominal interest rate is exactly the opposite of this: when the nominal interest rate is lower, people will think that the benefits of monetary savings have decreased, so they will increase consumption-consume current products. Therefore, on the one hand, people increase consumption, requiring producers to produce what people need immediately; on the other hand, increasing capital goods requires producers to produce useful things for the future, that is, things that can be combined into capital goods, not consumer goods that people need. The role of the interest rate market itself is to coordinate the production of the two, but now, the intentionally lowered nominal interest rate has transmitted the wrong signal. At the same time, the expanding demand for consumer goods and capital goods is contradictory, and one day, the person who set the investment plan will find that the price of the required resources is soaring rapidly-or, there are not so many real savings available-so it is impossible to complete the investment. But the investment that cannot be completed is meaningless. It means the complete bankruptcy of the investment plan.

The only support for this stimulus theory is that it seems difficult to find errors statistically - monetary expansion can indeed bring about an increase in the statistical concept of "gross domestic product" (GDP). This can be seen from the Fisher equation - the right side of the equation is similar to the concept of "gross domestic product" in statistics: the total amount of market transactions that occur within a certain time, a certain region (or group). However, GDP is just a number, not a measure of the benefits people obtain from the market, and these benefits cannot be measured - when people trade a bunch of grapes for 10 dollars, no one knows how much happiness they get from these grapes, or how much more happiness they get than they could get from 10 dollars. The stability of the GDP number does not mean that people have benefited or that a reasonable production-consumption structure has been formed. Perhaps this only postpones the outbreak of the crisis rather than eliminating it.

The theory of demanding currency contraction will also have the same problem.

All ideas that require "on-demand" changes in the amount of currency are demanding an arbitrary power that is above all market participants. This power can dilute the wealth of others at will and create obstacles for spontaneous transactions without any responsibility.

Currency Leakage

This is actually not necessary to discuss. The reason why metal currencies are superior to previous currencies is that they are easier to divide, so it is easier to obtain smaller currency units. Bitcoin has the same feature. In addition, it is possible to meet people's cash needs by speeding up the circulation of currency, which is something that technological progress can achieve.

Summary

We analyzed the impact of changes in the quantity of currency and examined whether "elastic supply" of currency really brings benefits to people. The result is that, at least for now, the arguments put forward by the proponents of elastic supply, especially the "stimulus theory," are untenable. Moreover, they will bring many problems. These problems are more real and destructive than the benefits proposed by supporters of elastic currency.

Shortage caused by currency leakage can be alleviated even if there are problems. You can think of the various "scalability" solutions currently appearing in the Bitcoin world as addressing this issue.

Some people may view Bitcoin's monetary policy as bold, while others see it as a reflection of centuries of human contemplation on currency issues.

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