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Why are all fiat currencies inflationary, and lose value with time? Could governments make them deflationary? What are the advantages of inflationary currency compared with deflationary currency?

Why was Bitcoin chosen to be deflationary (limited number of total coins)?

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There are many causes for inflation, but the two most often agreed upon, according to Investopedia, are these:

Demand-Pull Inflation - This theory can be summarized as "too much money chasing too few goods". In other words, if demand is growing faster than supply, prices will increase. This usually occurs in growing economies.

Cost-Push Inflation - When companies' costs go up, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of imports.

Fiat currency inflation absent these forces can be driven by the creation of money through speculative fractional reserve bank lending practices as well as simple "printing of money" by the central bank responsible for a government's currency. It is in the interest of the government's ability to spend that it be able to freely create money out of nothing, which is the veritable definition of fiat, Latin for "let it be".

Advantages of inflation include:

  • Steady rise in prices
  • Steady rise in value of non-liquid assets, e.g. not cash
  • Supposedly an indicator of growth

Disadvantages of inflation include:

  • Cost of goods increases because one unit of money does not have as much purchasing power as it did previously
  • Decrease in the value of stored liquid assets, e.g. cash in a non interest-bearing account
  • Potential for hyperinflation

Bitcoin's deflationary quality is based on the assertion that a currency must have scarcity in order to be valuable. By limiting what amount can enter the system, it ensures that no individual can increase the supply and inflate the value relative to physical goods.

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Fiat currencies are inflationary by design, so that people don't hoard currency. The more your money loses value every year, the less likely you are to keep it sitting in a bank. This availability of money in the market encourages the growth of the economy. When money is easy to borrow, entrepreneurs and businesses can use it to hire/build/invest, and pull forward developments that would otherwise have taken much longer.

This comes with the drawback that an increase of availability of money in the market causes an increase in prices and risky behavior, which as we know from history, can be very bad.

The US government tries to keep the inflationary nature of fiat currencies in check by regulating the interest rate from the root source of all money, the federal reserve bank. You can think of them as an infinite source of money which can be borrowed at a cost: the interest rate. When they increase interest rate, it increases the cost of tapping into that money, which slows down borrowing, hiring, investing, etc. If done too severely, it can result in a deflationary spiral.

As for why bitcoin was designed to have a fixed supply, I do not know. However, I can speculate two reasons. The first reason I can think of is simplicity. Since bitcoin is designed to be decentralized, it's not obvious who would play the role of the federal reserve. So, maybe Satoshi shrugged and said, let's just keep the supply fixed to start. The second reason is to give early adopters an incentive to start mining, akin to mining gold (Satoshi makes this analogy himself in his original paper).

What's interesting to consider is what if you made a cryptocurrency whose supply wasn't fixed, but rather expanded and contracted like fiat currencies. This was proposed in this paper, which is quite well-written, whether or not you agree with it. I am not an expert so I'll keep my opinion out of this post.

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