This makes things a bit difficult for any average person to understand. Well, if you want to know more about it, you are in the right place.
Here is an article that will try to demystify things in the best way possible and make you more knowledgeable.
If you consider inflation in its basic terms, governments usually debase gold coins to inflate a currency.
However, with technological advancements the government now inflates the fiscal base by creating money digitally and by revising the internal database to track fiat currency, and all these are mostly digitized now.
This is done to regulate the supply and circulation of money in the market so that its value does not drop dramatically with more money existing and fewer people using it.
It is the same concept followed in the crypto industry.
This is because the creators of Bitcoin have designed this coin with an inflation rate so that it imitates the inflation rate of gold that is considered to be most stable and to have the ultimate store of value.
But, gold is inflationary as well due to its unique characteristics – scarcity. No one can create gold because its supply is controlled by nature.
It is the same with crypto.
Is Crypto Inflationary or Deflationary?
Just like all those assets with a good store of value are scarce, every crypto too has a fixed amount of supply, and therefore scarce.
For example, Bitcoin has a fixed supply of up to 21 million and about 80% of that amount has already been minted.
This means that once it reaches that limit no one will be able to mine any more of these coins.
To keep the possibility and algorithmic inflation rate of Bitcoin in check, the mining difficulty is increased.
If it is found that these blocks are being generated much too fast, the level of mining difficulty is increased.
Also, when more and more people take part in the mining operations, the software will increase the difficulty automatically to mine Bitcoin successfully.
The reverse happens, that is the mining difficulty is reduced, when there are less people participating in mining and the new blocks are produced in less number for any given hour.
Based on the inflation rate, if the difficulty is readjusted to a high level it will be very difficult to mine more crypto coins simply by increasing the computer resources to a network.
In such a situation, either the transaction fees or the number of transactions will be increased.
Yes, this may happen considering the fact that Bitcoin is inflationary money, just like gold, and it is constantly decreasing at a predictable rate.
Though this may become stable over time the purchasing power of Bitcoin will keep on growing as well slowly as and when the demand for it increases.
With other things being equal, this means that the cost of each Bitcoin will increase when the rate of inflation decreases.
In order to create a regulated algorithmic inflation rate, the rate of inflation of Bitcoin is hardcoded into the software in particular that operates it.
This is pretty similar to the K percent rule of Milton Friedman and it eliminates the chances of human errors or manipulation of the monetary base due to political reasons.
The inflation algorithm of Bitcoin was however designed to make the coin even scantier than gold.
In order to have a better understanding of the matter, you should also take a look at Ether, the second most popular coin after Bitcoin.
It is considered to be deflationary in nature but how deflationary it is, is what you need to know given the fact that it has outperformed Bitcoin several times before even when both these coins had record high prices.
Ethereum seems to have taken the traditional selling point of Bitcoin seriously to represent its anti-inflation narrative.
It took into account the negative aspect of the difference between the numbers of coins issued and destroyed.
The negative issuance of the coins made people believe that it is deflationary and feel that it is necessary to have a hedge against the ominous inflation.
However, there is one significant difference between Bitcoin and Ether.
While Bitcoin has a limited supply cap of 21 million that will not be reached before 2140, there is no clear limit on supply of Ether, the native coin of the Ethereum network.
However, there is a lot of misinformation about Ether being deflationary but the main objective behind burning Ether, a process in which it is taken out of circulation, is to give the Ethereum network more capability to process more transactions.
The main idea behind it was to lower the user fees and not to make it deflationary.
This upgrade was introduced after the update of the network software called the London Hard Fork. Due to this upgrade, every operation made on the Ethereum network burns a tiny amount of its native coin, Ether.
This means that when there is a huge amount of transactions made on the network a considerable quantity of coins will be destroyed than mined.
However, such activities are also expected to cool off when there is a steep rise in the price of coins.
Typically, blockchain networks are self-correcting in nature and therefore when a network gains more attention due to the deflationary factors, the transaction activities will increase.
This will result in consequent increase in the transaction fees which will stop the increase in activities on the network and rebalance the coin issuance.
Therefore, whether a crypto coin is inflationary or deflationary is a factor that depends on whether the network goes from a technology play to a store value play or vice versa.
Inflation and Deflation Logic to Crypto
Therefore, with respect to currencies, there are basically two major groups of them out there: inflationary and deflationary.
The inflationary currencies are those that do not have any limit to the supply or in circulation in the market at a given point of time.
On the other hand, deflationary currencies are those that come with a definite supply.
When other factors remain the same, the purchasing power of the inflationary currencies gets reduced when more of them are produced or minted.
On the contrary, in the case of deflationary currencies the value of it increases over time as and when it tends to become scarcer.
All fiat currencies tend to fall under the inflationary currencies category but in the case of crypto coins, most of these coins are typically deflationary in one way or another.
This is because cryptocurrencies are not controlled by any external authority, institution or the government.
This means that the maximum supply of the crypto coins are typically determined by the respective algorithms.
This limit cannot be exceeded because when the limit is reached the supply of coins comes to a halt.
This results in the rise in prices of the crypto coins provided that the perceived demand for it remains the same.
In terms of mining the coins, the rewards will become smaller and smaller, a process called halving, which will make the coin truly deflationary, such as Bitcoin and Litecoin.
There are a few other crypto coins, such as XRP, the native coin of Ripple, which is considered to be deflationary in a different way.
The company issued its entire supply of 100 billion coins right at the very start.
However, 55 billion of the total number were escrowed or locked in a specific account.
On the other hand, the remaining number of coins is reducing day by day because a small amount of the coins is burnt or destroyed when a transaction takes place.
However, there are also a few other specific types of crypto coins, such as Ether, that do not have any hardcoded limit in terms of their supply or the number of coins that can be created.
These are mainly those Proof of Stake or PoS coins. Still, this does not mean that the coin is inflationary.
Since most of the crypto coins are deflationary by nature, a time may come when people will hold these coins relentlessly.
This will make it quite difficult to buy any more of these coins. It will be quite expensive as well, if you get a chance to buy some fortunately.
With its unique nature, crypto plays a significant role during inflation.
Over the last decade, Bitcoin and crypto coins have literally proved to be a good alternative during inflationary periods.
This is because the deflationary nature of crypto gives it a store of value that protects against hyperinflation which causes the rise in prices of everyday goods and services.
These coins cannot be manipulated by increasing the supply or by changing the interest rates.
The extreme and questionable volatility of the crypto market is also a fundamental reason for its deflationary attribute.
When prices of coins increase, more and more institutional money starts pouring into the market.
On the other hand, when the prices fall the same investors tend to flock back to gold.
Moreover, the crypto market is still considered to be in its nascent stage as compared to the gold market that existed from time immemorial.
It is immature and therefore lacks stability making it an unsafe haven in terms of store of value which is essential for it to be considered as a good hedge against inflation.
However, the stablecoins seem to be a good alternative since these are more secure and less volatile being pegged with USD.
These stablecoins offer a diverse range of benefits to the people living in hyperinflationary countries.
It also helps in making day to day transactions without needing to deal with the volatile fiat money in hyperinflationary economic conditions.
Understanding Inflationary and Deflationary Crypto Tokens
The veracity or authenticity of the financial world of today has been transformed by the Decentralized Finance or DeFi protocols.
With the use of smart contracts, these platforms have helped the tokens to take the center stage when it comes to making any financial transactions.
All these tokens have their unique features facilitating the existence of both inflationary and deflationary tokens in the crypto market.
The inflationary tokens in the crypto market follow the basic concept of inflation with a little difference from the inflationary fiat money.
Until the limit of supply of the coin is reached, the number of coins in circulation continues to increase since the Proof of Work model rewards the miners with new tokens for their mining efforts.
On the other hand, the Proof of Stake or PoS model issues coins to the liquidity providers. Either way, the number of coins increases in the system.
The supply of these inflationary tokens surpasses the demand for them over time and therefore loses their value as a result of the discrepancies with the demand and supply.
The number of deflationary tokens, on the other hand, decreases over time since the supply is regulated by removing the coins from circulation.
This is done in two specific methods namely, buy back and burn and burn on transaction methods.
In the buy back and burn process the tokens are simply taken out of the system and made unusable.
It is the same process followed in the stock markets where the company issuing them buys a significant amount of it back, preventing them from being accessed by the general public.
This entire process reduces the supply and increases the demand for the coin which subsequently increases the value of it.
On the other hand, the burn on transaction process involves removing a part of the transaction fee charged by the blockchain network every time a transaction is made on it and is confirmed.
This makes the coins deflationary.
Therefore, the concept of deflationary tokens may be new but it exists.
There are lots of new coins coming up every day like mushrooms but all of these coins may not last for long due to their deflationary nature.
What is Crypto Based on Inflationary and Deflationary Essentials?
The inflationary or deflationary nature of crypto is just the same as the fiat currencies.
This is why you should know about the fiat currencies first.
If you consider the traditional currencies, these are used to be fixed.
The value of these currencies was typically pegged with material goods such as gold. This is held as reserve by a central bank.
The value of the particular currency is defined on the basis of this gold reserve which indicates how much gold the currency can buy when people go to the central bank and demand gold for their money.
Later on, in the 1970s, such gold reserves were abandoned by the central banks, and a few specific countries abolished it completely.
In such a situation, the money became floating. This means that the value of a specific currency was determined based on the value of some other currency.
This value is actually a general agreement that the two currencies really have some value.
It is for this reason these currencies are called ‘fiat’ currencies – the Latin for ‘let it be done.’
As a result of abandoning the gold standard, fiat currencies became inflationary.
This means that the central banks can now print currencies according to their whim and fancy and for that they do not even need to make any prior announcements to the public.
As a result, the amount of money in the market keeps on rising which creates an adverse impact on the buying power.
Now, coming to cryptocurrencies, the concept is the same where more coins in circulation will reduce the value of the coins, thereby causing inflation.
And, on the other hand, reducing the number of coins in circulation will increase the demand and value of the deflationary coins.
Effects of Supply of Coins
The inflationary and deflationary nature of the crypto coins has some notable effects in its supply. Once again, what happens in the world economy also happens in crypto-economics.
Since the supply of the coin is affected due to inflation or deflation, it affects the long term prices which you need to analyze and speculate while making an investment.
Now, which is better, you may ask, among having a finite or an infinite supply.
Well, this is a topic for debate though the analogy of the two is not very hard to understand.
Still, you will need to have full clarity of the terms and the concept.
Coins that have a finite supply will have a total supply value and a circulating amount.
While the total supply indicates the number of coins that have been created until now, the circulating supply is the number of coins available in the market for trading.
You will need to know and consider these numbers while evaluating your crypto investment.
Apart from that, you must also understand the lifecycle of the coin along with some other key metrics.
These metrics regarding circulating or total supply are not hard to find or understand since these are published publicly.
When a digital scarcity is created, it affects the valuation of the crypto coins directly.
When any particular crypto coin which has no limit in its supply is staked or mined constantly it will reduce the demand for it in the long run and will also pull down its price along with it.
But, in the case of deflationary coins, it is due to their uniqueness that the rise in demand from the profit-hungry investors will cause the price to rise.
If you consider the fiat system, the deflationary currencies are typically saved by the stakeholders.
They hope that the value of it will rise in the future. It is the same in crypto as well.
This is because the effects of liquidity experienced by the capital markets are not different from the supply and liquidity in the crypto market.
Also, the fact that the central banks can change their monetary policies annually such as increasing the currency supply that reduces the intrinsic value of money, it is not much different in crypto.
However, the most significant difference is that while blockchain technology has been able to hold an indifferent attitude when it comes to coin printing, many governments have not been able to do so.
This significant characteristic of the blockchain technology that runs the cryptocurrencies has helped it to offer an effective solution to inflation, one of the worst economic conditions in history.
Valued Based Analysis
It is the inflationary and deflationary nature of Bitcoin and cryptocurrencies offer unique insights into the dynamics and value analysis.
Typically, value has different forms and it is very difficult to understand it when it comes to the store of value and a medium of exchange.
Even if you put the scalability aspect aside, the usefulness of crypto as a store of value is debatable and even the critics of Bitcoin sometimes fail to understand and argue on it.
This is because crypto, Bitcoin in particular, has failed to be the ‘electronic cash’ yet as it was intended but unquestionably symbolizes one of the most lucrative and potentially stable stores of value.
When it comes to storing value, people follow different ways for it.
They either keep their fiat money in the banks, or invest it in other valuable assets like gold, gems and other precious metals.
All through history, these methods have proved to be the most stable ways to build wealth.
However, inflation does not help these value storage models because the returns are mediocre or low considering devaluation of currency.
Also, storage is also a problem in the case of precious metals that need to be left with a third party for that matter.
Bitcoin or crypto coins are different in that way. These coins are deflationary and typically have a finite supply.
These are also convenient to store and carry and most importantly it is you who have complete control over your funds since these are unregulated and need no intermediaries.
The issuance of mining rewards, which is halved after every four years for Bitcoin also affects the value of crypto.
This resolves the problems of inflation created by the government-backed currencies.
As it is, the macroeconomics is complicated and the central banks are highly unlikely to change their monetary policy to support deflation.
Therefore, the crypto coins with their novel technology, consensus systems and blockchain architecture transfers deflationary value storage in the long term into the digital dominion instead of physical assets like precious metals and gems.
The ability of crypto coins other than Bitcoin to plan or change the issuance rates at preset values also helps in money supply and value analysis.
Typically, inflation or deflation rates are set leaving no room for making any changes in it.
This means that the people will know the value and will also know what to expect well in advance.
This will help them to make financial decisions and build systems based on a solid value.
In terms of store of value and exchange, once again the dynamics of Bitcoin is in the line of fire.
People wonder whether it can function as both at the same time.
This is because currencies need to be very stable in value to be used as a medium of exchange and Bitcoin certainly is anything but far from stable.
Therefore, a price fluctuation after a transaction can cause a lot of issues and difficulties in calculating the value paid in excess or deficit.
So, Bitcoin cannot be used as a medium of exchange for everyday purchases due to its extreme volatility.
Therefore, the answer to the question whether or not a currency can function both as a medium of exchange and store of value is still not available.
The fiat money seems to be an excellent option but then again there is the risk of poor value of storage and devaluation in the long term.
This means that even the dollar can function as either a medium of exchange or as a store of value but not as both.
It is due to the intricacies in the financial systems of the central banks that tailors inflation rates carefully in order to aggregate monetary metrics more realistically.
Now, this raises another question: how sustainable will this model be even if the long term value of the US dollar is stabilized.
Well, nothing cannot be said for sure because this is something that has eluded the national currencies for long primarily due to the complexities of tying it to banks and government institutions both.
On the other hand, in the case of Bitcoin and other cryptocurrencies, they exist outside the banks and governments both.
This is surely a distinct advantage that is lacking in the fiat currencies.
Using its decentralization technology it is perhaps possible by Bitcoin and other cryptocurrencies to offer an effective solution to the problem that the economists have been looking for a long time now.
It can be used to make micropayments instantly without needing any intermediaries to deal with the parties involved in a transaction.
This eliminates a significant financial hurdle and answers a lot of questions that may come to your mind as well as in other people regarding store of value and its analysis.
It is quite hard to realize the concept of inflationary and deflationary aspects of crypto with relation to fiat money.
While loans are everywhere in the traditional monetary system, crypto is still nascent. However, it seems to have come at the most opportune moment.