How the economy works and why people are buying Bitcoin

Throughout history, many methods of trading, barter, and paying have been invented. From trading tools to stones, commodities, precious metals and even paper bills. In the time of today, we are already used to not only paying with real bills and coins but also by transferring money online.

The history of money

Before we can get an understanding of how and why bitcoin was invented, we should start to look at the history of money.

Barter (non-monetary system)

When we go back in time, more than 100.000 years ago, the common way to get what you needed (or wanted) was to barter with someone. If you wanted a tasty chicken but only had grain to trade, you would have to look for someone who had chickens and was interested in trading it for grain.

Monetary system

Barter wasn’t ideal thus instead, humankind started adopting a monetary system.

But how do you convince people to trade their valuable belongings for something seemingly worthless like a piece of paper or metal? The solution to this was the promise to back what was then considered money, by something valuable, like gold. So if people wanted to, they could trade their money in for gold coins.

(There were other examples as well. But, let’s fast forward to the 19th century as this will be most relevant to understanding Bitcoin.)

The gold standard

During the 19th and 20th centuries, it was a widely used practice to base a monetary system on a fixed quantity of scarce substance, in most cases gold, called “the gold standard”. This meant that each dollar was worth a fixed amount of gold and therefore had a fixed amount of value.

However, after two world wars and countries having insufficient funds to run their wars, the gold standard got abandoned.


Fiat money

Since the gold standard has been abandoned, money doesn’t hold any intrinsic value anymore. This means the currency we use today is only backed by government regulation.

So it is no longer a precious metal or scarce product that dictates how much money should be in the system, nowadays, it’s the government that does. This means the government can choose to print additional money or increase or decrease interest rates.

Inflation & deflation

What the government, let’s say the federal reserve, will try to do is to increase the amount of money in the system accordingly with the growth of the economy. There are several metrics that the federal reserve uses to measure whether to print money or to decrease or increase interest rates.

When the government increases the amount of money in the system faster than the value of goods produced, the value of money decreases, call it inflation. When the opposite is true, money deflates and becomes worth more. In times of inflation, people tend to spend more, deflation makes people hold on to their money.

Booms & recessions

Usually, the government will try to have a moderate amount of inflation, about 2 to 3 percent. Moderate inflation motivates people to spend money or to invest, which stimulates economic growth.

However, when inflation becomes too high, it will have a negative effect on the economy because the prices of goods and services are rising to fast. One of the stimulants of high inflation is printing money or when there is too much credit. Banks rely on a fractional reserve banking system that allows them to lend in excess of the amount of actual deposits on hand. Therefore, a portion of credit is nothing more than money created out of thin air. So the more people borrow, the more money there is in the system. If money becomes less scarce, prices of goods and services rise.

In times of high inflation, the government will increase interest rates to discourage borrowing and thus decreasing the amount of money in the system.

Nevertheless, if inflation is too low, or deflation occurs, prices tend to remain the same or drop. This means that the same amount of money would buy you more goods or that the economy would stagnate. Deflation is also disastrous for the economy. If the value of money increases over time, people would delay spending it, because they believe their money will buy them more in the future.

So what does all of this mean for the economy?

If people spend less, companies earn less and demand for goods and services decreases. If companies earn less and demand decreases, those companies shrink. If companies shrink, they need fewer employees. This, in turn, increases unemployment. When unemployment increases, people have less money to spend. Since one person’s spending is another person’s income, the economy keeps contracting. It’s called a recession.

And what does the government do to solve this?

In times of low inflation or deflation, the government will print money and lower interest rates. This brings more money in the system and therefore increases spending, which should, in turn, increase demand for goods and stimulate the economy again.

If you want to get a better understanding of how all of this works, I highly recommend you watch this video made by Ray Dalio which explains this subject very well and understandable.

alice-pasqual-Olki5QpHxts-unsplashPhoto by Alice Pasqual on Unsplash

Bitcoin, the new gold standard

Bitcoin is what is referred to as a “cryptocurrency”. Cryptocurrencies like Bitcoin are digital assets that have a decentralized control and aren’t regulated by government authorities.

” Bitcoin is not “unregulated”. It is regulated by algorithm instead of being regulated by government bureaucracies. Un-corrupted. ~ Andreas Antonopoulos

andre-francois-mckenzie-vBYVj-yycwQ-unsplashPhoto by André François McKenzie on Unsplash

How does bitcoin work?

Bitcoin works through what is called “the blockchain”. This is a shared public ledger on which the entire Bitcoin network relies. All the transactions that occur are calculated in a certain mathematical problem. When a certain number of approved transactions is reached, a new block is formed and added to the blockchain. So all transactions that have ever taken place are encrypted and stored within the blockchain.

What is Bitcoin mining?

Bitcoin miners use special software to solve mathematical problems. The solving of these mathematical problems is necessary for Bitcoin to work and to add transactions to the blockchain. The computers that helped to solve the mathematical problems are then awarded a small portion of Bitcoin.

Why do people buy bitcoin?

Bitcoin isn’t regulated by the government and is backed by the fact that only 21 million Bitcoins will ever be produced. This means it’s a scarce product. Another thing that convinces people is that it is an anonymous way to transfer value and to complete transactions. Bitcoin is also very secure, the mathematical problems are hard to solve and need big computing power. Trying to hack Bitcoin is considered nearly impossible. To even make the smallest gains by doing fraud, someone would need to be extremely well organized and have access over extremely powerful, costly power-consuming computers.

So Bitcoin is secure, anonymous and scarce (apart from unpredictable market fluctuations).

Should you buy bitcoin?

Currently, an investment in Bitcoin would be considered speculation. No one knows for sure what will happen with Bitcoin. Over the years, the price of a Bitcoin has been very volatile.

Why is Bitcoin called “the new gold”?

Bitcoin has from a value standpoint similar traits as gold. For example, it’s hard to mine and the more Bitcoin gets mined, the harder it gets. This means it has a very small and stable increase in volume, similar to gold. Another trait it has in common with gold is scarcity and the fact that its value can’t be undermined by government interference.

Where can you learn more about bitcoin?

If you find this article interesting you should definitely read this book: The Bitcoin Standard ~ Saifedean Ammous. In this book, you will read more about barter, how we transformed into a monetary system and how it revolutionized into the economy we know today. After reading this book you will have a clearer understanding of Bitcoin, why it was invented and how it works.

Photo by Ilya Pavlov on Unsplash

Author: Bjorn Callewaert

"I am an investor, content creator and Front Line Manager. Here I share the things I learned about Investing, productivity, minimalism, and personal finance."

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