The Economics of Bitcoin: How does Bitcoin price rise & fall
in Bitcoin (BTC)
What makes the Bitcoin Price go up and down?
After the great price swings of May 2021, crypto hodlers and traders alike know full well how volatile Bitcoin and other cryptocurrencies can be.
This article aims to break down the dynamics of BTC price action and explain in mathematical detail exactly why Bitcoin is so volatile.
We also wish to help crypto users understand the economics of Bitcoin, and to come to terms with Bitcoin volatility!
The Bitcoin Market Price is Determined by the Laws of Supply & Demand
The price of Bitcoin (BTC), like any other asset, currency or tradable item, fluctuates because it is governed by the laws of supply and demand, which determine the market price of an underlying asset. This can be illustrated in Figure 1, where Demand (D0) and Circulating Supply (S0) meet at the Market Price also known as the Equilibrium Price (E0).
As the demand for an asset such as Bitcoin increases, whilst the circulating supply stays the same, the price of Bitcoin, BTC to USD, will rise as people are willing to pay more for the asset due to increased demand from D0 to D1 and stable supply at S0, moving the equilibrium price of Bitcoin BTC to USD from E0 to E1 or P0 to P1 as there are more Bitcoins being demanded in the market going from Q0 to Q1 (See Figure 2).
However, if the demand for an asset such as Bitcoin decreases whilst the circulating supply is fixed, the price of Bitcoin, BTC to USD, will fall as depicted in Figure 3 as demand decreases from D0 to D1. This will move the equilibrium price of BTC to USD from E0 to E1 or P0 to P1 as there are now less Bitcoins being demanded in the market going from Q0 to Q1.
The same principles governing the price action of BTC to USD also apply to the changes in the circulating supply of an asset such as Bitcoin traded in a marketplace or exchange given a stable demand for the asset. Generally speaking, if the circulating supply of an asset like Bitcoin decreases whilst the demand of Bitcoin stays the same, the decrease in circulating supply from S0 to S1 would not be able to meet the existing demand at D0. Therefore the price of BTC would increase from E0 to E1 because there will be a Bitcoin supply shortage (Q0 to Q1) and buyers will be willing to pay a premium in terms of BTC to USD (P0 to P1), as depicted in Figure 4 below.
Conversely, if the circulating supply of Bitcoin were to increase from S0 to S1 whilst the demand stayed the same at D0, the increased quantity of Bitcoins circulating in the marketplace (Q0 to Q1) would decrease the price of the asset as there are more sellers wanting to sell Bitcoin than there are buyers who are willing to buy Bitcoin. Therefore the sellers would be inclined to sell their asset at a discounted price as the Bitcoin Price, BTC to USD, falls from E0 to E1 (illustrated in Figure 5).
An asset such as Bitcoin has a unique supply structure such that only 21 million Bitcoins (BTC) exist in terms of the total supply of Bitcoin. Additional Bitcoins cannot be added as there is a limited supply making it a scarce asset with people often referring to it as “digital gold”. This is one of the reasons Bitcoin has had such phenomenal price rallies. That being said, the circulating supply of Bitcoin (the number of Bitcoins circulating in the market) can vary as people tend to hold (or HODL) when things are perceived to be bullish for Bitcoin and sell when things are perceived to be bearish for Bitcoin. Therefore the Bitcoin Price, BTC to USD, has seen dramatic price rallies & dumps and is also subject to extreme volatility due to changes in the factors of the supply and demand of Bitcoin, discussed below.
Supply & Demand Factors That Could Increase the Bitcoin Price (BTC to USD)
The Bitcoin Price (BTC to USD) has been rising recently, and may continue to rise, due to the following factors that either increase the demand of Bitcoin or decrease the circulating supply of Bitcoin:
1. Bitcoin Halving
Approximately every four years, the Bitcoin mining block reward is cut in half, known as the Bitcoin Halving. With the block reward reduced by 50%, there is supply shortage to Bitcoin circulating supply. This decrease of Bitcoin availability causes Bitcoin to become ever more scarcer and valuable. Historically, the price of Bitcoin has increased and hit all time highs after each Bitcoin Halving event as illustrated in the Bitcoin price chart below.
2. Increased Monetary Supply or Money Printing
As discussed above, when the supply of an asset or currency increases, the asset or currency loses its value relative to another asset or currency. The US has been printing unprecedented amounts of US Dollars to boost the US economy since the 2008 economic crisis, and even more so as a response to stimulate a post pandemic economy. In 2020 alone, the Federal Reserve printed more than 20% of all US Dollars ever created in history. The US Dollar has therefore weakened against other assets like Bitcoin and Gold as asset prices have risen to make up for decline in the US Dollar value.
3. Increased Inflation or Hyperinflation
Rise in inflation is a direct knock on effect of the currency depreciation caused by excessive money printing. When the value of currency is falling, the prices of assets relative to that currency start to increase in general. One of the most notable examples of a currency crisis that led to hyperinflation is in Zimbabwe. From around 1999, the government of Zimbabwe began printing money to pay for excessive government spending such as payouts to veterans, propping up the failing economy and military expenditure for Zimbabwe’s involvement in Congo's civil war. The excessive money printing did not stop and the Zimbabwe Dollar depreciated against other currencies and assets so much that it eventually gave rise to hyperinflation. During hyperinflation in Zimbabwe, prices of goods and services were updated multiple times a day, rendering the currency essentially worthless.
4. Demand from Institutions & Corporations
There has been an increased demand from institutional investors and corporations to put BTC on their treasury balance sheet. With the state of the economy, increased money supply, the disparity between the stock market & the real economy, institutions and companies such as Micro Strategy have bought large amounts of Bitcoin as investments on the Treasury Balance Sheets. The surge in institutional demand for Bitcoin has led to a domino effect causing many other companies to do the same and purchase large amounts of Bitcoin. This news has caused the BTC to USD Bitcoin price to also surge as there are fewer Bitcoins left in the market for retail investors. As more and more institutions and companies buy Bitcoin, the increase in demand for Bitcoin will have a positive correlation to increase in the Bitcoin price.
5. Media Hype
Constant media interest and hype surrounding Bitcoin creates a positive perception about the industry and its future. The perception of increased demand for BTC creates a fear of missing out (FOMO). The FOMO created by the hype leads people to panic buy into Bitcoin causing the price of Bitcoin to surge.
Payment services providers such as Paypal have begun to offer the ability to easily buy Bitcoin and other cryptocurrencies to their existing customers and merchants easily from their platform. This has given access to millions of customers and businesses to buy Bitcoin, enabling the adoption of cryptocurrencies. As more people have access to buy crypto and cryptocurrencies become more mainstream, the demand for crypto increases along with the price of Bitcoin and other cryptocurrencies.
Supply & Demand Factors That Could Decrease the Bitcoin Price (BTC to USD)
The Bitcoin Price (BTC to USD), can also see price decreases due to the following factors that either decrease the demand of Bitcoin or increase the circulating supply of Bitcoin:
1. Dumping Large Amount of Coins in the Market
When whales (large Bitcoin and crypto holders) dump coins onto cryptocurrency exchanges, there is a more Circulating Supply of Bitcoin than there is demand, causing the market price of Bitcoin to decline. This can also happen if a government seizes Bitcoin from illegal operations, then sells the BTC at auction, usually way below market price, which is then dumped onto exchanges.
2. Media FUD
Media articles consistently spreading fear, uncertainty and doubt (also known as FUD) influences perceptions negatively about Bitcoin and the crypto market, causing people to sell their holdings.
3. Whale Manipulation & Inexperienced Traders
The price of Bitcoin can be influenced by manipulating the perception of the market players. Usually this is done through spreading FUD through media channels. New and inexperienced traders using high amounts of leverage usually end up playing into the hands of the whales and selling their holdings causing volatile price drops.
4. Government Bans & Strict Regulation
Cryptocurrencies are still pretty unregulated and have been subject to government crackdowns and threats to be all out banned. This causes the Bitcoin price to drop as people, especially new traders, sell their Bitcoin and crypto in a panic.
Will the Bitcoin Price keep rising or falling in the future?
Since its inception, Bitcoin has had many bull cycles where the price of Bitcoin skyrocketed and many bear cycles where the BTC price plummeted to a price correction.
With this cyclical nature it is reasonable to expect that the Bitcoin price will see eventual pullbacks and corrections on it’s way up as adoption increases. In the short term, the Bitcoin price will have it’s inherent volatility. However, over a long enough time frame, the demand for Bitcoin has been pushing the Bitcoin price higher and higher since its inception.
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This content is for informational purposes only and is not investment advice. You should consult a qualified licensed advisor before engaging in any transaction.