Why do encryption traders need to understand the economic framework?

Core Highlights

• What is an economic model: An analytical tool that simplifies complex economic phenomena, helping to predict price fluctuations, market trends, and policy impacts.
• Four Basic Elements: Variables, parameters, equations, and assumptions together form the framework of every economic model.
• Cryptographic Applications: Understanding the impact of supply-demand relationships, transaction fee mechanisms, and policy changes on coin prices.
• Practical significance: It is not just theory, but an important reference for judging market trends.

Why Economic Models Are Important for Cryptocurrency Investors

Most people find economics too complex and dull, but in reality, economic models are the “keys” to understanding market rules.

In the cryptocurrency market, prices do not emerge from thin air. They are influenced by multiple factors such as supply levels, user demand, policy changes, and technological upgrades. The role of economic models is to connect these seemingly unrelated factors, helping you understand: Why do coin prices rise? Why do they fall? What might happen next?

Traditional financial markets have been making decisions based on economic models for decades. If you still rely on emotions and gossip to trade, you will easily be taken advantage of. Conversely, if you learn to analyze the market from an economic perspective, you will be able to assess risks and opportunities more rationally.

The economic model consists of four key elements.

1. Variable - A factor that can change

Variables are elements in a model that fluctuate and directly affect the final outcome. The most common economic variables include:

• Price: The trading price of goods or assets
• Quantity: The scale of production or trading (for example, trading volume)
• Income: Disposable funds of individuals or institutions
• Interest Rate: Borrowing Cost

In the cryptocurrency market, variables include the price of coins, on-chain transaction volume, user growth, transaction fees, and more.

2. Parameters - Fixed rules

Parameters are relatively stable settings in a model that determine the specific strength of relationships between variables. For example, a model may state: If the interest rate increases by 1%, investment will decrease by 2%. Here, “decrease by 2%” is the parameter.

In economics, there is a classic concept called NAIRU (Non-Accelerating Inflation Rate of Unemployment), which represents the unemployment rate when the labor market is in equilibrium. This is an example of a parameter.

3. Equation - The mathematical relationship between variables

Equations express how variables influence each other in mathematical language. The most famous example is the Phillips Curve:

π = πe − β (u−un)

It looks complicated, but it's simple when broken down.

• π = actual inflation rate
• πe = expected inflation rate
• u = Actual Unemployment Rate
• un = natural unemployment rate
• β = sensitivity coefficient

This formula illustrates a phenomenon: the lower the unemployment rate, the easier it is for inflation to rise. This is also applicable in the crypto market— the hotter the market, the more funds there are, and the easier it is for coin prices to soar.

4. Assumption - Premise of the simplified model

Models cannot completely replicate reality, so assumptions must be made to simplify the problem. Common assumptions include:

• Rational Decision-Making: Assume that everyone is rational and will maximize their own benefits.
• Perfect competition: The market has enough buyers and sellers, and no one can individually control the price.
• Ceteris Paribus: When analyzing a certain factor, it is assumed that other factors remain unchanged.

These assumptions sometimes do not align well with reality (for example, the market is often irrational), but they are necessary conditions to make the model actionable.

Complete Analysis Process of the Supply-Demand Model

This is the most basic and practical economic model, which can be fully applied to the cryptocurrency market. Taking apple trading as an example:

Step 1: Identify Key Variables and Relationships

Variables include:

• P = Price
• Qd = Quantity demanded (the amount consumers are willing to buy)
• Qs = Supply quantity (the amount producers are willing to sell)

The relationship is the demand curve and the supply curve.

Step 2: Set Parameters

Assume:

• Price elasticity of demand = -50 (if the price increases by 1 dollar, the demand decreases by 50)
• Supply price elasticity = 100 (if the price increases by 1 dollar, supply increases by 100 units)

Step Three: Establish the Equation

• Qd = 200 − 50P
• Qs = −50 + 100P

Step Four: Solve for the Equilibrium Point

Let Qd = Qs:

200 − 50P = −50 + 100P

250 = 150P

P = 1.67 USD

Substituting gives: Qd = 116.5 units

This means that at a price of $1.67, the market reaches equilibrium—the quantity consumers want to buy is exactly equal to the quantity producers want to sell.

If the price is above $1.67, there is an oversupply, and the price will drop. If the price is below $1.67, there is an excess demand, and the price will rise. This is the process of automatic market adjustment.

Step 5: Apply to Cryptocurrency

Exchange apples for Bitcoin and dollars for USDT. When the supply of BTC increases (except for the reduced output after halving) while demand remains unchanged, the price is likely to fall. Conversely, the same applies. This is why halving events usually drive up the price of coins—it changes the parameters on the supply side.

Six Different Types of Economic Models

Visual Model

Use charts and curves to show economic relationships. Demand curves and supply curves belong to this category. The advantage is that it is intuitive and easy to understand, while the disadvantage is that it cannot handle complex situations.

empirical model

Test economic theories with real data. For example, collect BTC price and trading volume data from the past 3 years and see how strong the correlation is between them.

mathematical model

Theories expressed purely through equations can be very precise but also very abstract. Most academic papers use this approach.

expected-driven model

Consider people's expectations for the future. For example, if the market expects the Federal Reserve to cut interest rates, investors will start increasing purchases now, leading to a price increase in advance. This is particularly evident in the cryptocurrency market—any “positive” rumors can drive up prices.

simulation model

Simulate various economic scenarios using computer programs. You can assume: “What would happen if regulations suddenly tightened?” and then observe the model's output.

Static vs Dynamic Models

Static Model: Provides a snapshot at a certain moment. The supply-demand model is static and only shows the current equilibrium point.

Dynamic Model: Incorporate time factors to see how variables change over time. For example, analyze the entire process of a policy from announcement to implementation and then to the manifestation of effects. Dynamic models are more complex but also closer to reality.

Three Major Applications of Economic Models in the Cryptocurrency Market

1. Understanding the Fundamental Causes of Price Volatility

The logic behind the rise and fall of coin prices is the competition between supply and demand.

• When a new cryptocurrency is listed on a major exchange → Demand surges → Price rises
• When the currency undergoes halving → supply decreases → there is a basis for price increase
• When the market falls into panic → demand plummets → prices drop

By analyzing these phenomena using the supply-demand model, you can determine whether price fluctuations are a short-term emotional response or a long-term trend change.

2. Analyze the impact of transaction fees on the ecosystem

High transaction fees can suppress usage. For example, during a bull market, Ethereum's gas fees soar, discouraging many small traders, which actually leads to a decrease in transaction volume. At this point, using a transaction fee model for analysis can predict a significant increase in demand for layer 2 solutions (such as Arbitrum and Optimism).

3. Simulating the Impact of Policy Changes

If a country is to impose a crypto tax, or if the U.S. SEC is to change regulatory rules, economic models can help you predict how the market will react. This is not a 100% accurate prophecy, but it can provide you with a rational thinking framework.

Limitations of Economic Models

It must be said candidly that the economic model is not perfect:

Assumptions are not realistic Consumers in the real world often behave irrationally, there is market manipulation, and information is asymmetrically distributed. The model assumptions of “perfect rationality” and “perfect competition” are difficult to find in reality.

Over-simplification Models will overlook many details for the sake of operability. For example, supply-demand models ignore complex factors such as psychological expectations, technological innovations, and policy changes. This means that the predictions of the model may deviate from reality.

Data Quality Issues Garbage in, garbage out. If the data itself is inaccurate or biased, the results produced by the model are also unreliable.

Practical Application Scenarios of Economic Models

Policy Evaluation

Governments or project teams use models to assess the consequences of certain policies. For example, a public blockchain considering increasing rewards for validators can use models to predict the impact on ecological security and token inflation.

prediction and planning

Use models to predict future trends and help businesses with long-term planning. An exchange can use models to predict trading volumes for the next 6 months and adjust server capacity accordingly.

business decision

The project team uses economic models to design token economics. When to release how many tokens? How much should the staking rewards be set? All of these can be quantified and analyzed using models.

Four Essential Economic Models

Supply-Demand Model

The most basic. Understand it, and you will understand the fundamental logic of the market.

IS-LM model

Explain the balance between the commodity market and the currency market. Although it is macroeconomic, it is helpful for understanding how central bank policies affect the entire financial market.

Phillips Curve

This explains the inverse relationship between inflation and unemployment. At certain times, this curve can also explain the rotation phenomenon of “risk asset speculation vs safe-haven asset conservatism” in the cryptocurrency market.

Solow growth model

Study how long-term economic growth comes from labor, capital, and technological progress. Applied to the crypto ecosystem, it is to understand why a certain public chain can grow in the long term - is it due to an increase in the number of users (labor), an increase in ecosystem builders (capital), or technological breakthroughs (innovation).

Summary

Economic models are neither “mysticism” nor “fortune-telling”. They summarize complex phenomena into an analyzable mathematical framework.

For cryptocurrency traders, the value of learning economic models lies in:

1. Establish a Systematic Thinking: No longer relying solely on news-based trading, but using logical analysis to understand why prices move.
2. Improve prediction accuracy: Although it cannot fully predict the future, it can significantly increase the win rate.
3. Reduce Emotional Decision-Making: When you can speak with data and models, you are less likely to be swayed by market emotions.
4. Understanding Policy Impact: Understand from an economic perspective how macro factors such as regulation and interest rate changes transmit to the cryptocurrency space.

The next step is to delve deeper into the application of the supply-demand model and token economics model in practical projects—this is the true embodiment of “knowing and doing in one.”