What drives Bitcoin’s Price?

The value of Bitcoin, unlike traditional currencies like the U.S. Dollar or Euro, isn’t controlled by a central bank. Instead, Bitcoin’s price is determined by supply and demand. Bitcoin’s hard supply cap of 21 million coins creates scarcity, which can drive prices up when demand grows. Conversely, demand dips can lead to price decreases. Additional factors, like mining costs, regulatory changes, news events, and competition from other digital assets, also influence Bitcoin’s supply and demand dynamics, contributing to price movements.

Bitcoin’s decentralized nature and lack of government backing lead some to question the basis for its valuation. However, Bitcoin’s unique attributes, particularly its scarcity and independence from traditional monetary policy, continue to attract investors who see it as a hedge against inflation and fiat currency instability.

Supply and Demand for Bitcoin

Like traditional currencies, Bitcoin’s price is primarily determined by supply and demand. When demand for Bitcoin rises, so does its price; when demand falls, the price drops.

Factors that increase Bitcoin’s utility—such as the development of the Lightning Network, which makes transactions faster and more cost-effective—can increase its adoption and boost demand, ultimately pushing up the price.

On the supply side, Bitcoin is unique. Its issuance schedule is fixed and entirely inelastic, meaning no increase in demand can accelerate Bitcoin’s production. Unlike fiat currencies or commodities, where production can ramp up in response to demand, Bitcoin’s mining process is governed by a difficulty adjustment that maintains steady issuance, regardless of demand.

Stock-to-Flow Model

The stock-to-flow (S2F) model is frequently used to analyze the impact of Bitcoin’s scarcity on its price. Stock-to-flow measures the current supply (stock) relative to the new annual production (flow), essentially indicating an asset’s scarcity. According to S2F, assets with higher ratios, like gold and Bitcoin, should theoretically command higher prices due to their scarcity.

Every four years, Bitcoin’s issuance rate undergoes a “halving,” reducing the supply of new bitcoins entering circulation. Each halving increases Bitcoin’s stock-to-flow ratio, enhancing its scarcity. While past halvings have preceded price increases, the S2F model’s reliability is still a subject of debate. Bitcoin’s current inflation rate is approximately 0.8 % annually, and it will continue to decrease over time. In comparison, gold’s annual inflation rate is around 1.6% to 2% due to ongoing mining production, meaning that, unlike Bitcoin, gold’s supply will likely continue to grow at a steady rate as more reserves are discovered and extracted.

Bitcoins Supply Inflation Rate, Source: BitBO

How Bitcoin’s Scarcity influences the Price

Bitcoin’s limited supply has a significant impact on its price. With only 21 million bitcoins ever to exist, Bitcoin’s fixed supply gives it a degree of scarcity that fiat currencies lack, as central banks can create unlimited new currency. This scarcity exerts upward pressure on Bitcoin’s price, particularly as demand grows.

Bitcoin’s transparent monetary policy further strengthens its appeal as a store of value. Since the maximum supply and issuance schedule are well-known and predictable, investors are assured that their holdings won’t be diluted by sudden increases in supply, making Bitcoin a strong inflation hedge.

Compared to fiat currencies, whose supply and inflation rates are at the discretion of central authorities, Bitcoin’s fixed supply creates confidence among investors, particularly in times of inflationary pressures on traditional currencies. However, this finite supply also makes Bitcoin more sensitive to demand fluctuations, contributing to its price volatility.

Inflation and Deflation

Inflation, typically caused by rapid increases in money supply, erodes purchasing power as prices rise. Bitcoin’s deflationary nature, due to its capped supply, protects it from inflation. Historically, fiat currencies with no supply limit have faced episodes of hyperinflation, which has at times rendered them worthless, as seen with the German Mark or Zimbabwean dollar.

In contrast, Bitcoin’s fixed supply supports its value as a long-term store of wealth, similar to gold. Concerns over deflationary risks are often overstated, as supply and demand balance has corrected previous Bitcoin price declines, making it a resilient asset against inflationary and deflationary pressures.

Final Thoughts

• Bitcoin’s Price: Driven primarily by supply and demand dynamics.
• Scarcity: Bitcoin’s finite supply mitigates inflation, making it appealing as a long-term store of value.
• Stock-to-Flow Model: Used to analyze scarcity’s impact on price but remains debated.