Inflationary and Deflationary Cryptocurrencies
Key Takeaways
- Cryptocurrencies can be inflationary, deflationary, or have a supply that doesn’t change
- Inflationary cryptos are cryptocurrencies with growing supply
- Cryptocurrencies can be deflated when the amount of burned cryptocurrency over time is higher than the newly minted coins
What Are Inflation and Deflation?
What is Deflation
Deflation is the reduction in the supply of money in circulation. It can also be defined from the perspective of purchasing power as an increase in the purchasing power of money due to its scarcity. In reality, deflation might negatively affect the economy.
First, it can lead to a decrease in economic activity. This happens because manufacturers are forced to reduce the price of their products to stimulate buying activities, leading to lower profit margins and resulting in lower wages/household incomes. Second, deflation can lead to an increase in debt. This happens because when prices fall, the value of debt increases. This can put a strain on households and businesses and can lead to defaults and bankruptcies. Moreso, deflation can cause a decrease in asset prices. This happens because when prices fall, the value of assets such as property and stocks also falls. This can lead to a loss of wealth and can make it difficult to borrow money since the collateral value shrinks.
While deflation can have negative effects, it is not always a bad thing. For example, deflation can lower the cost of living for people on fixed incomes. In addition, it can encourage people to save money and can lead to increased investment in productive assets.
Usual Causes of Deflation
Fall in The Money Supply
One of the main ways that a central bank can influence the economy is by changing interest rates. If the central bank raises interest rates, it becomes more expensive to borrow money. This can discourage spending and encourage people to save/lend more. Thus, higher borrowing costs can slow down economic growth, which we know is largely driven by spending. All this can lead to deflation.
The central bank can also use other tools to influence the economy. For example, the central bank can buy or sell government bonds. This can help to increase (money printing in layman’s terms) or decrease the money supply in the economy. The central bank can also set reserve requirements for banks. This means that banks have to keep a certain amount of money in reserve and cannot lend it out. Less liquidity in the economy means less spending which creates deflationary pressures.
Decline in Confidence
The economy may enter a recessionary phase when people lose confidence in its future. This can lead to a decrease in spending, as consumers save more and postpone major purchases. Businesses may also cut back on investment and expansion plans, further reducing demand in the economy. The overall effect of this can be a decline in aggregate demand, leading to a decrease in economic growth.
Lower Production Costs
When production costs decline, it leads to increased output and an oversupply in the economy. If demand remains unchanged, producers will need to lower their prices on goods to remain competitive. Technological advancements are a major driver of lower production costs, hence lower prices.
What is Inflation
Inflation refers to an economic situation where the prices of goods and services are rising. As a result, purchasing power gets lower as goods usually cost more. Inflation can either be demand-induced or supply-induced.
Most times, economists expect a ripple effect, once an economy is inflated, causing more inflation. When inflation occurs in a slow-growing economy, the concept is referred to as stagflation.
What Causes Inflation?
Inflation can either be demand-induced or cost-induced. However, both still find their roots in the basic economic laws of demand and supply.
Demand
When the demand for goods and services increases more than the supply, it causes demand-induced inflation as prices go up.
Cost
Unlike demand-induced inflation, where demand increase, in cost-induced inflation, demand remains the same, but for some reason, the supply is affected. Basic economic laws dictate that then the demand is more than the supply, and the prices are raised.
A good example can be seen in the price of oil. Demand can remain the same for a long time, but say a cost increase in machines used for oil extraction can cause the prices to be inflated.
Fixed vs Floating Currencies
A fixed currency is pegged to a more stable asset. The value of the currency in relation to other currencies is determined by the nation’s financial institution.
Floating currencies, on the other hand, are currencies that have exchange rates determined by the forces of demand and supply. Examples of the fixed currencies are Bahrain and Hong Kong, both pegged to USD.
Inflationary vs Deflationary Crypto
Cryptocurrencies can be inflationary, deflationary, or have a constant supply. Each type of crypto has its advantages, but investors' sentiments are generally turned towards cryptocurrencies without high inflation because of how their scarcity is perceived to help its value increase long term. Inflationary crypto, on the other hand, helps the cryptocurrency subsidize mining/staking and marketing efforts. Let’s take a look at a few factors that makes crypto deflationary.
Supply
The difference between these two categorisations of cryptocurrencies is in their supply. As their name implies, inflationary cryptos continue to supply the native cryptocurrency to the market, thereby increasing the total supply. On the other hand, deflationary cryptocurrencies might still release new cryptocurrencies into the supply, but at the same time burn more coins/tokens than they create, reducing the cumulative total supply.
Factors That Determine the Economics
Why do countries go through seasons of inflation and deflation? There are lots of answers to this question, but with cryptocurrencies, the answer is more direct.
With inflationary cryptocurrencies, the focus is a planned increase in the total number of tokens in circulation. The new coins/tokens often come as mining/staking rewards.
The other type, deflationary crypto, uses a system where the total supply reduces over time. It is done by burning fees or the mining rewards, or both. To be more specific, here are three key factors that help differentiate between an inflationary and deflationary cryptocurrency.
- Maximum Supply
As its name suggests, the maximum supply of a cryptocurrency is the hard cap of the crypto. It refers to the total number of tokens it can ever have. An example of crypto with a hard cap is Bitcoin (21 million BTC).
- Circulating Supply
This is used to describe the amount of cryptocurrency units that have been released to the circulation.
- Total Supply
The total supply refers to the total cryptocurrencies minted on the network. It takes note of the circulating crypto plus the locked and vested tokens.
What is Deflationary Crypto?
Let’s take a look at a list of deflationary cryptocurrency
FTT
FTT is the cryptocurrency that powers the FTX exchange. It was created in 2019 on Ethereum but has been later augmented to function on other networks too. To enforce its deflationary nature, the exchange periodically burns a third of all fees generated from transactions, 10% of any amount added to its insurance fund, and 5% from fees generated from other activities.
Bitcoin (BTC)
The most well-known cryptocurrency is the first on our deflationary tokens list. Bitcoin has been believed to be both inflationary and deflationary. New Bitcoins are introduced to the blockchain roughly every ten minutes. The thesis on its deflationary nature hinges on its 21 million cap.
No new Bitcoin will be released after this limit, and with the number of lost private keys, the Bitcoin in circulation will be scarce.
Ripple
Another well-known coin, XRP, serves as the platform's default token on the Ripple network. The transactions that take place on the platform are subject to fees, but unlike other platforms, the fees are neither returned to the network nor given to validators. As a result, XRP becomes a deflationary token.
Binance Coin (BNB)
Binance coin is one of the deflationary cryptocurrencies out there. Every quarter, it burns a part of its token, and it aims to continue this trend until 100 million BNB tokens have been burned. The amount of tokens to be burned each quarter is generated from a formula that takes the number of blocks produced on Binance Smart chain into consideration.
Is Ethereum Deflationary or Inflationary?
Ethereum was designed to be an inflationary cryptocurrency, as it does not have a maximum supply, but in preparation for transitioning to the proof-of-stake, an upgrade called the London upgrade was implemented in August 2021. A part of it, the EIP-1559, involves burning the base fee on every transaction.
When transaction count increases, the burn rate makes Ethereum a deflationary cryptocurrency. Although no one can make an accurate Ethereum price prediction for future years, it seems logical that with the number of features Ethereum has to offer, a deflationary pattern could push the price upwards.
Importance Of Supply Limits
Why should cryptocurrency supply have a cap? Why shouldn’t they be printed till infinity like fiat currencies are?
As much as we compare cryptocurrencies to fiat, we should also look at them from the perspective of them being investable assets. Supply limits help an investor gauge how scarce a cryptocurrency is, and when combined with price, investors can have a picture of the market’s perception of the project.
Сan a Cryptocurrency Be Both Inflationary and Deflationary
Yes. Take Ethereum. This cryptocurrency is both inflationary and deflationary. With the launch of the London upgrade, when the network is congested, the burn rate is very high, making it deflationary. Other times, it is inflationary with new coins entering circulation in the form of staking rewards.
Wrap-up
The economy of many traditional currencies was designed such that in case of any economic strain, the government could print more money, invariably weakening the currency. And even though there are no governments behind decentralized cryptocurrencies, inflation is often a tool used by the teams designing and maintaining various crypto projects. On the contrary, deflationary cryptocurrencies rely on the scarcity factor to drive the value of the chain up.
It’s crucial to note though that an inflationary currency with a lot of market attention will do better than a deflationary currency with little to no demand, hence this single factor can’t determine the success of a particular crypto.
Frequently Asked Question
- Why is cryptocurrency deflationary?
A cryptocurrency is deflationary because its total supply reduces due to burns or reduced validator fees.
2. Is Ethereum deflationary?
Depending on the network conditions, London Upgrade allowed for huge fee burn when congestion is high, making the blockchain deflationary. If the traction on the blockchain is low, Ethereum remains inflationary currency.
3. What is a deflationary token?
A deflationary token is one that has its supply reduced over time. This would mean that the burn rate is higher than the amount of new tokens entering the market.
4. Is Bitcoin inflationary or deflationary?
Bitcoin is inflationary until it reaches its maximum supply, which is capped at 21,000,000 BTC.
5. Is XRP a deflationary coin?
Yes. Ripple is deflationary in nature albeit through a different process. The project released the total 100 billion XRP to the market, but escrowed 55%. Because a part of the fees are burned, the supply of ripple reduces .
6. Is shiba inu deflationary?
Yes. Shiba Inu token is a deflationary cryptocurrency.
7. How do you get deflationary tokens?
The same way you buy an inflationary token; from an exchange, minting, or peer-to-peer. There is no difference in how to purchase both. The primary difference is their supply mechanism.
8. Is deflationary currency good?
Yes. Both inflationary and deflationary currencies can have their advantages. For the deflationary currency that has lots of attention, the scarcity will spur the price to shoot up. The scarcer the tokens available, the more people will want to pay to get the available ones.
9. Is Cardano deflationary?
Currently, No. But when Cardano reaches its maximum supply in 2030, it won’t be inflationary anymore.
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