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Inflation and deflation with a fixed money supply

The U.S. dollar, bitcoin, and the gold standard

In the United States, we typically pay for goods with U.S. dollars. Hence, the consumer price index (CPI) looks at a basket of goods priced in U.S. dollars. But what if the CPI were priced in Bitcoin? The FRED graph above shows the inflation rates for this basket of goods in U.S. dollars (blue line) and in Bitcoin (red line).

Even our currently high inflation rate in U.S. dollars is dwarfed by the towering peaks of the inflation rate in Bitcoin—not to mention Bitcoin’s wild gyrations. Never in the history of the U.S. dollar has the inflation rate reached the heights that Bitcoin has on several occasions in a few years.

Bitcoin also exhibits severe deflations. That’s problematic for a currency used for transactions: With deflation, consumers expect goods to become less expensive and thus wait to buy, which can lead to a collapse of the economy. Given that the dollar has been available (and not deflating), there was no economic collapse. To be clear: Bitcoin is used very little for transactions anyway, maybe because of these repeated deflations.

To continue being clear: The U.S. dollar also has had deflationary episodes, although not as severe. Our second graph is the same as our first graph but with the addition of a few other price indexes starting in 1850. You can see several episodes of deflation. (Use the sliders below the graph to exclude the Bitcoin years for better visibility.) Each of those deflationary episodes is associated with a recession, noted by the gray shading.

Notable dollar deflations haven’t happened for a long time. Why not? All the significant deflations happened during a period where the supply of U.S. dollars was tied to the quantity of gold: in other words, when the U.S. economy was on the gold standard. With no means to manage the supply of dollars, there was no way to avoid fluctuations in price when the demand for money fluctuated. After the Federal Reserve was created in 1913, it was at least possible to alleviate regional variations in money demand by shuttling cash across the nation, but the total quantity of money was set.

Bitcoin is similar in that it also has a more-or-less fixed quantity that cannot respond to fluctuations in demand. Thus, its price is bound to fluctuate more than the U.S. dollar, the supply of which the Federal Reserve can manage to avoid high inflation, deflation, and inflation volatility.

How these graphs were created: First graph: Search FRED for “CPI” but don’t click on the first choice. Seek out the series that covers from 1913 to today, which is not seasonally adjusted (as the other series are). From the “Edit Graph” panel, use the “Add Line” tab to search for the same CPI series. Then add a series to the second line by searching for “Bitcoin.” Apply formula a/b and at the bottom of the form choose the units “Percent change from previous year.” Finally, limit the visible years to those that have Bitcoin data. Second graph: Add new lines by searching for “general price level” and “index of wholesale prices.” Make sure they’re also expressed as percent changes and expand the window to include all years.

Suggested by Christian Zimmermann.

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