What Makes Bitcoin Special? An Economist Explains

Why is it so volatile?

“Since bitcoin’s supply is essentially fixed, its price fluctuates due to changes in demand,” Luther says. “Bitcoin is more volatile than many other assets because it is a medium of exchange. It is more volatile than other media of exchange because it lacks a core, reliable source of demand.”

“Media of exchange are subject to what economists call network effects,” he explained. “No one wants to use a [form of] money that no one else is using. Everyone wants to use the same money that their trading partners are using.”

“Therefore, my decision to accept bitcoin makes it more desirable to you, and vice versa,” Luther continued. “The network effect means that small shocks to demand are amplified, since anything making bitcoin more attractive to me also makes it more attractive to you and everyone else by virtue of the fact that it is more attractive to me. The same process works in the opposite direction for anything making it less attractive to me.”

Again, comparing bitcoin to the dollar can help us understand this phenomenon.

“With other monies, there is some core group of users that everyone can count on with near certainty to accept it,” Luther said. “The U.S. government, for example, stands ready to accept dollars in payment of taxes and fees. It seems very, very unlikely that it will stop doing so. That core group of users provides a lower bound to the demand for dollars… as a result, demand tends to be fairly stable.”

“That’s not the case with bitcoin,” the economist continued. “It’s not unreasonable to think its demand could fall to zero. So we are constantly on guard against that prospect. Relatively small disturbances lead some to reevaluate their positions. And bitcoin’s price fluctuates as a result.”

Will Bitcoin Ever Catch on For Widespread Use in Everyday Exchange?

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