Ether is the underlying token powering the Ethereum blockchain, but it serves a slightly different purpose than bitcoin does to the Bitcoin blockchain. Although ether is traded on public markets and has displayed price appreciation similar to bitcoin, they are quite different by design. Ether is not intended to be a unit of currency on a peer-to-peer payment network; rather, it acts as the “fuel” or “gas” that powers the Ethereum network.
At the highest level, Ethereum is an open-source platform that runs smart contracts. When smart contracts are run on a blockchain, they become self-executing when certain conditions are met. The execution of smart contracts requires computational resources that must be paid for in some way: this is where ether comes in.
Ether is the crypto-fuel allowing smart contracts to run. It provides the incentive for nodes to validate blocks on the Ethereum blockchain, which contains the smart contract code. Every time a block is validated, 5 ethers are created and awarded to the successful node. A new block is propagated roughly every 15–17 seconds. Some nodes may find the correct solution to a block without having it included in the network. The Ethereum network rewards these nodes with 2–3 ethers.
Individuals interacting with decentralized applications on the Ethereum platform will have to pay the network in ether for the use. Developers are incentivized to create these decentralized applications because they will be paid in ether for their work. Developers are also incentivized to write quality applications because wasteful applications will be more expensive and likely will not be used as frequently as better alternatives.
Using this information, the narrative around ether becomes more clear. Its final use will most likely be abstracted by basic button clicking, but assuming Ethereum becomes widely used, ether will be rapidly moving between users and miners. Its value is directly tied to the use of the Ethereum blockchain.
Is Ether Inflationary?
The total supply of ether is not capped like the total supply of bitcoin. 60 million ether were created during the initial crowdsale, 12 million of which went to early backers and the Ethereum Foundation. Most of the money raised will be used to fund future development initiatives.
Ether’s issuance model is unique in that it does not emphasize deflation like most other popular cryptographic assets. Initially, issuance of ether was capped at 18 million per year, which is 25 percent of the initial supply raised in the crowdsale. But more recently, Vitalik Buterin said that issuance levels will be contingent on security rather than a predetermined schedule. Although this rate is fixed each year, the monetary inflation rate actually decreases every year, making ether a disinflationary currency. Disinflation occurs when the rate of inflation shrinks over time.
Ether is expected to be lost each year because some users may forget their private keys, some may pass away without transmitting their private keys, and some may send ether to an address without a corresponding private key. As the network grows, it is expected that the annual rate of ether lost will equal the annual issuance rate. The hope is that ether will be deflationary in 2140, around the same time that Bitcoin ceases issuing new coins. For an in-depth analysis of Ethereum’s issuance model, read Joseph Lubin’s piece.
These calculations are not set in stone. Ethereum is expected to switch its consensus algorithm from proof of work to proof of stake, which in theory is supposed to be more efficient and requires a smaller mining reward. This change has produced some uncertainty within the ecosystem. The Ethereum Foundation is currently researching potential monetary effects and claims that all changes to the network will be handled by smart contracts, as opposed to individuals who may have ulterior motives.