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Berentsen and Schär
1.7 Consensus Mechanism
The consensus among miners is that every miner who receives a block candidate with a
valid fingerprint adds it to his or her own copy of the Bitcoin Blockchain. From a game theo-
retical perspective, a strategy profile where all miners add valid blocks to their own copies of
the Bitcoin Blockchain is a Nash equilibrium. If a miner believes that all other miners are act-
ing accordingly, then it is a best response for that miner to add a valid block candidate to his
or her own copy of the Bitcoin Blockchain. A deviation is not worthwhile, because it is not
profitable to work on a version of the Bitcoin Blockchain that is not generally accepted. Any
reward for finding blocks on a version of the chain that is not accepted by anyone else is worth-
less. Thus, although there is no authority enforcing this rule and miners are free to modify
their copy of the Blockchain as they wish, there is a strong incentive to follow this rule. This
self-enforcing rule allows the network to maintain consensus about the ownership of all
Bitcoin units. 4
Mining is expensive, as the computations use large amounts of electricity and are increas-
ingly dependent on highly specialized hardware. Moreover, valid block candidates can be
found only through a trial-and-error procedure. The consensus mechanism is therefore called
“proof of work.” If a miner finds a valid fingerprint for a block candidate, then this is proof
that he or she has, on average, performed a large number of costly computations. Adding
false information (e.g., illegitimate transactions) to a block candidate would render the block
candidate invalid and essentially waste all the computations. Finding a valid fingerprint is
therefore proof that the miner helped to maintain the Bitcoin system.
1.8 Monetary Policy
Ever y payment system needs rules that regulate how new monetary units are produced
(or destroyed). The Bitcoin network is calibrated in such a way that, on average, a block can-
didate with a valid hash value is found every 10 minutes. The winner of the mining contest
receives a predefined number of newly created Bitcoin units. The number currently is 12.5.
In the Bitcoin system, money creation is scheduled so that the number of Bitcoin units
will converge to 21 million units (Figure 5). This limit exists because the reward for the miners
is halved every 210,000 blocks (approximately every four years). Correspondingly, miners
will be increasingly rewarded through transaction fees. But even today, the quick processing
of a transaction can be guaranteed only if an adequate fee is paid to incentivize the miners to
include the transaction in their block candidates.
Most Bitcoin users believe that Bitcoin’s limited supply will result in deflation. That is,
they are convinced that its value will forever increase. Indeed, up to this point we have wit-
nessed a spectacular price increase from essentially a value of $0 for one Bitcoin unit in 2009
to a value of $7,000 at the time of this writing (Figure 6).
Nonetheless, these beliefs need to be challenged. Bitcoin units have no intrinsic value.
Because of this, the present price of the currency is determined solely by expectations about
its future price. A buyer is willing to buy a Bitcoin unit only if he or she assumes that the unit
will sell for at least the same price later on. The price of Bitcoin, therefore, reacts highly elas-
Federal Reserve Bank of St. Louis REVIEW
First Quarter 2018
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