If you remember something about your economics class in college, you might remember Milton Friedman’s classic theory, also known as the quantity theory of money. To put it shortly, Friedman argued that price correlates directly to the amount of money that circulates. We can apply this logic to bitcoin so that we have a starting point for its valuation, in order to do this, we use the equation of exchange: MV = PQ.

Explaining the formula

Let’s start by explaining what this formula means.

M = is the current stock of money, as in, how much money is circulating

V = stands for the velocity of it, meaning how fast it changes hands

P = is the price level

Q = is the economy’s output

We can say that PQ stands for the nominal GDP or the total expenditures based on the prices of goods and services that an economy produces in a year.

According to Friedman’s logic the velocity of money was stable and the Q variable barely moves. The output of an economy tends to have a really small decrease or increase every year.

Because of this, our formula will now look like this: MV = PQ. V and Q are usually constant, if more money is supplied by a central bank, it leads to an increase of the same proportion to the price level of every good produced. Real wealth isn’t created by the printing press, if the money supply increases faster than the growth of the economy, inflation is bound to happen.

Applying Friedman’s logic

For starters, the M variable is constant. There is no third party involved in supplying more bitcoin into the market. The market is capped at $290 billion and constantly on the rise which proves the code is good, additional to this let’s take into account that counterfeiting bitcoin can’t be done. Let’s also assume like Friedman would, that bitcoin has a constant velocity, making our variables look like this: MV = PQ. So now M and V are our constant variables.

Next, we define the P and Q variables in the bitcoin system. Q is the utility that derives from the use of bitcoin, so we divide 2 identifiable groups of people that give use to it: The people that want to get off the grid and the ones that want to be on the grid, a good example would be people sending money abroad from a country that works under a very rigid or strict economic system, while another group of people might use it for multiple illegal activities.

Additional to this, we also have to take into account the people that have no access to the world financial system, such as people in war-torn countries like Afghanistan or Iraq, or people that live in a country working under a failing economic system, like Venezuela. These people are allowed to get on the grid and have access to bitcoin.

Because of this, the change of the M and V variables is directly proportional to Q, meaning that the market cap changes according to how much this payment system is needed and used.

Next, we divide fiat currency price (P) determined by our Q variable, by the velocity (V). This in turn will determine the market cap of bitcoin, meaning: M = PQ/V. If we follow what Friedman says, the price level is directly proportional to the money that circulates, this means that an increase in the money supply means that prices go higher. So, if we apply this to bitcoin, the market cap of bitcoin will change in proportion to changes in the Q variable. This changes the roles, instead of M pulling up our PQ variables, Q pulls up our M variable.

If we put some numbers on these, we have a starting point for bitcoin valuation. If you do some quick math, it will tell you that the market cap should be a lot higher than 290 billion dollars.