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Controlling for inflation in a PoW network with unlimited coin supply

by Lucas Leger

In the history of money, episodes of hyperinflation have ruined economies and populations alike, from Germany in the 1930’s, to Zimbabwe and Argentina more recently. Mismanagement in monetary policies, notably through carrying out excessive money printing, can have long-lasting and dire economic consequences. Primarily, such excessive money printing destroys purchasing power. Assume for instance that I hold 10 coins that used to buy 10 coffees last year. But today, I can only afford 8 coffees with these coins. It means that the coins have lost 20% of their value, and so has my purchasing power.

To the extent that controlling inflation has been the main concern in Central banking history, the occurrence of monetary mismanagement has frequently been a problem. The stability of the banking model rests mostly upon the level of trust in this institution that is displayed by the population. The public trusts that the central bank will not carry out policies that will decrease the currency’s purchasing power. To a large extent, Bitcoin was created to avoid “inherent weaknesses of the trust-based model” [1], which occur when financial institutions are the necessary middleman behind every economic transaction. The merit of Bitcoin is to provide a secure online payment system where the coin supply cannot be tampered with by any government or centralized authority.

It is useful to recall here Bitcoin’s economic dimensions. Its monetary policy is known by everyone to be able to be anticipated, but not altered. More precisely, new bitcoins are minted within a specific timeframe and at a specific issuance rate, making everyone aware of the approximate monetary mass in circulation. Since Richard Cantillon and David Hume, it has been known that monetary mass has a direct effect on global prices. These authors posit that inflation is triggered by an increasing amount of money in circulation, such that the amount cannot be absorbed by the transaction needs of a given economy, over a given period. Therefore, everything else being equal, prices should go up. To put it simply, the more money that is printed, the higher that prices rise.

By design, with its limited supply, and its strict monetary policy, Bitcoin is not inflationary. On the contrary, it is deflationary. A coffee denominated in bitcoins in 2020, costs less than it did in 2010. Constraining the supply of money makes the system less prone to inflation. If we follow the quantitative approach of money given by Cantillon and Hume, and later refined by modern economists, then as we said above, inflation is a tax on purchasing power. And — thanks to its design — Bitcoin can play its role as a store of value.

Limited coin supply has often been seen as the ‘go-to’ policy for cryptocurrencies, but this approach also has its downsides. For one, adjustments to demand shocks are always reflected in prices, which can partly explain the high volatility rates on these markets. Secondly, it makes exchange rates artificially higher than their fundamental value, by creating scarcity. Overall, the currency has value because it has transaction purposes [2]. That is why cryptocurrencies are more often referred to as an asset class, rather than a currency.

In JAX.Network, we posit that it is possible to maintain value in the coin, while not having limited coin supply. Unlike conventional Proof of Work blockchains, JAXCoin supply does not grow at a pre-specified growth rate. Instead, the reward for miners is proportional to the amount of computing power they are ready to allocate to secure the network. Our reward (R) function for mining one shard [3], is as follows:

With k being a coefficient which allows us to parametrize the cost of mining, and D being the difficulty, with

We had two working assumptions while designing the coin: I) that miners are rational agents, who seek to maximize their expected profit, and II) that the total coin supply is a function of miners’ operation costs. The costlier the mining process, then the fewer coins that they are going to produce. It turns out that these assumptions are not too restrictive. They also provide enough economic incentives for a steady rate of coin issuance, while simultaneously maintaining the security of the network.

Despite the theoretically unlimited supply of our coin, scarcity is economically bounded by the fact that a miner will not allocate resources if such an allocation is not profitable for him. Miners must adjust the supply to both their cost structure and to the new transaction needs of the network. Therefore, the money supply cannot grow above both the cost of energy and the productivity gains observed in the hardware mining equipment.

This cost-based approach to issue coins is new. In our design, supply shocks are unlikely to occur. Furthermore, JAX.Network is not affected by the type of long-term deflationary problems that are inherent to Bitcoin, as well as to other commodity monies, because the coin supply will adapt to demand through a non-cooperative game. Indeed, miners are price takers who compete through quantities. They adjust the quantity of hash power according to other miners’ choices. Therefore, the total quantity of global production depends only on the sum of marginal costs.

As the reader can see, our coin supply management approach differs from the approaches of most mainstream cryptocurrencies, as well as from fiat currencies. Economists have so far criticized cryptocurrencies on the ground that they are privately issued monies lacking legal tender. This is only partly true, as there are other ways to build trust. We can make sure that our coin’s fundamental value is based on transaction needs because:

  • It is not cheap to produce an extra coin. At best, marginal costs are not decreasing, but remain constant. Our reward function makes sure that the production costs of one coin far exceeds the production costs of paper money;
  • There is no credit in the system. When we compare cryptocurrencies to other private currencies (before central banking became the norm in the 20th century), economists often overlook the fact that miners cannot lend money. They only make a profit through the coins that they mint, and they, therefore, have no interest in printing more than what is necessary for transaction purposes.

Overall, miners always adjust to market conditions, as it is in their economic interest to do so. Our main goal is to achieve coin price stability without resorting to risky hedging, and the use of stable coins, therefore providing a blockchain-based means of payment that has long-term stability.

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Sources:

  1. Satoshi Nakamoto. “Bitcoin: A Peer-to-Peer Electronic Cash System”. Bitcoin white paper.
  2. Jean Tirole. “Asset bubbles and overlapping generations”. In: Econometrica: Journal of the Econometric Society (1985), pp. 1499–1528.
  3. Our network can be split into different shard-chains that work in parallel. For more technical details about our network, you can refer directly to our Whitepaper: https://arxiv.org/pdf/2005.01865.pdf.

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