How Cryptocurrencies Are Linked to Inflation and Deflation

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  • Inflation has recently reached record highs globally.
  • A crypto can either be inflationary or deflationary.
  • BTC could become a deflationary coin if the demand for it remains the same post the last BTC coin being minted.

Inflation is a topic making rounds in the markets and the news as inflation figures have reached recently record highs globally. Notably, inflation is when prices of goods and services rise. On the other hand, deflation is when prices of goods and services decrease.

The balance between these two sides of the economic coin is delicate since an economy can quickly swing from one condition to the other. This is why central banks keep an eye on the level of price changes and introduce a monetary policy to stem inflation or deflation.

This article will cover what inflation and deflation are exactly, what inflationary and deflationary cryptos are, and how bitcoin (BTC) could be an inflation hedge.

What Is Inflation?

Inflation is the quantitative measure of the rate at which the price of goods in an economy is increasing and is caused when the demand for goods and services is high. This, therefore, leads to a drop in the availability of these goods and services.

These supplies can drop for several reasons, such as a natural disaster wiping out a food crop, or a housing boom exhausting building supplies. Whatever the reason, consumers are willing to pay more for the items that they want, resulting in manufacturers and service providers charging more for their products and services.

The most common measure of inflation is the rate of increase in the consumer price index (CPI), which is a theoretical basket of goods, including consumer goods and services, medical care, and transportation costs. The government then tracks the goods and services in the basket to gain an understanding of the US dollar’s purchasing power.

Inflation is seen as a big threat, especially in periods when it runs wild, such as the inflation seen in the late 1970s. These so-called hyperinflations occur when the monthly increases in prices exceed 50% over some period of time. Oftentimes, these rapid increases in prices are followed by a breakdown in the underlying economy.

Fortunately, hyperinflations have been historically rare. In reality, inflation can either be a good or a bad thing, depending on the reasons and the level of inflation. As a matter of fact, a complete absence of inflation can be bad for an economy since a modest amount of inflation actually encourages spending and investing.

What Is Deflation?

As mentioned, deflation is when the prices of goods and services decrease. This happens when there are too many goods available and not enough money circulating in an economy to purchase those goods.

For example, should a certain type of car become highly popular, other manufacturers will begin to make a similar vehicle to compete. Soon, car companies have more of that particular vehicle style than they can sell. They must therefore drop the prices of that particular vehicle.

Companies that find themselves stuck in a situation with too much inventory need to cut as many costs as possible to prevent the business from going bankrupt. This cutting of costs normally results in employees getting laid off.

These unemployed individuals do not have enough money available to purchase items, so they cut back on their expenditures. This creates a snowball effect as prices are then lowered further.

Credit providers also keep a close eye on the prices of goods and services, and when they see that prices are decreasing, they reduce the amount of credit that they are willing to offer. This results in a credit crunch where consumers are unable to access loans to purchase large items, which in turn leaves companies with overstocked inventory — causing further deflation.

Just as out-of-control hyperinflation is bad, so too is the uncontrolled decline in prices, as it can lead to a deflationary spiral.

Inflationary and Deflationary Cryptos

Inflationary Cryptos

A cryptocurrency is inflationary when the number of tokens in circulation is on the rise. These new tokens are introduced to the network through either mining, minting, or staking. As the token’s supply increases, its value decreases. Simply put, a crypto holder will need to spend more tokens of the crypto to purchase a particular thing over time.

Perhaps the most well-known example of inflationary crypto is the meme coin, DogeCoin (DOGE), as one of its creators abolished the token’s hard cap of 100 billion tokens in 2014, ensuring it had an unlimited supply. This means that the supply of DOGE could outpace investor demand for DOGE, leading to a decrease in the value of each DOGE token.

Then there is Bitcoin (BTC), which is also inflationary crypto but up to a certain limit. BTC has a fixed supply of 21 million coins, but not all of the tokens are in circulation yet. Tokens are introduced to the supply through a process called mining, which rewards transaction miners with BTC that is not in the circulating supply at the time of mining.

However, once the last BTC coin enters circulation, nobody will be able to mine for new BTC coins. At this point, BTC will shift into a deflationary cryptocurrency.

It will still be some time before BTC will become deflationary crypto as the network is currently configured to only introduce the last BTC in the next century. The reason for this is that the BTC network employs a process called halving to slow the token’s inflation. This cuts the number of bitcoins that can be minted and introduced to the circulating supply every four years.

Deflationary Cryptos

On the other hand, deflationary cryptos have a supply that will decrease over time instead of increasing. Should the demand for the crypto remain the same, the price of each coin will then rise as the supply reduces over time. Each deflationary crypto in the crypto space implements different deflationary measures.

For example, the biggest crypto exchange by trading volume, Binance, destroys some of its Binance Coins (BNB) every three months. Then some projects operate like a central bank. These projects employ both deflationary and inflationary measures to keep the value in check.

Ethereum’s native token, ether (ETH), used to be an inflationary coin. However, an update in August 2021 mandated that some of ether’s supply is burned when the network activity rises to make the coin deflationary.

Ripple (XRP) chose a completely different method to keep its token deflationary. Initially, 100 billion XRP tokens were released. In 2017, Ripple locked away 55 billion of these tokens and released them periodically to maintain liquidity.

Furthermore, every transaction on the XRP network includes a transaction fee, which is then burned to maintain the token’s deflationary nature.

Why BTC is Considered an Inflation Hedge

The reason why some people believe bitcoin can also be an inflationary hedge is that Bitcoin’s supply is capped at 21 million coins, while the number of US dollars typically increases over time. With everything else being equal, should the supply of the US dollar increase, the dollar value of bitcoin should theoretically increase too.

Assuming the market cap of Bitcoin and the US dollar are the same, then a simple example would be that the value of a single bitcoin should double as the supply of dollars doubles. Once again, this is speaking theoretically. However, the market doesn’t always work in this simple way as other factors can come into play.

BTC’s Prospects as an Inflation Hedge in the Future

This is still up for debate as we get closer to mining the last bitcoin of the capped 21 million supply. Granted that the last bitcoin won’t be mined until much later, it is interesting to see what will happen when the last bitcoin is mined.

If the demand for bitcoin is the same when, and post, the last bitcoin is mined, we could see bitcoin head into a deflationary model where each bitcoin becomes more and more valuable as the scarcity remains constant but demand either remains the same as well or rises.

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