By Hassan Mehmood (Saudi Arabia)
Introduction
Cryptocurrencies are introduced as an alternative to paper currency and traditional finance. It means that cryptocurrencies can perform every financial function on a decentralized basis as the placeholder for fiat currencies. Therefore, it also means that blockchains and cryptocurrencies can make a significant impact on the economy.
In traditional finance, the exchange of stocks, commodities, real estate, and fiat currencies are the core byproducts that determine the direction of an economic system. However, in DeFi blockchains, stablecoins, NFTs, Web3 apps, dApps, cryptocurrencies, and other products play the same role in the economic process. With the view of their economic impact and function, cryptocurrencies can be divided into inflationary and deflationary assets.
What is Inflation?
Inflation is one of the setbacks in an economic system. It happens when the prices of goods and services increase in comparison to the previous period. Some economists believe that a consistent and small rise in inflation is an indicator of a healthy and growing economic system. However, there are also some cases where inflation is the result of a bigger economic setback, such as a recession. In 2022, the USA is facing an 8.2% inflation rise which is greater than the expectations of the government regulators and the highest in the last 40 years.
What is Deflation?
Deflation is the opposite of inflation, and for consumers, it is nothing more than good news. Deflation happens when the prices of goods and services decrease over time. It can also mean that the purchasing power of the individual in the economy will strengthen on account of deflation.
Deflation is a result of the increasing value of the fiat currency or legal tender in a given region. It can also happen due to an increase in the supply and productivity of aggregate production in a country. Deflation usually happens when the fiat currency in a country is present in a limited quantity.
Key Differences Between Inflation and Deflation
At its core, inflation and deflation is the direct product of the money supply. It means that when the fiat currency in a country is present in limited quantity, it causes deflation. Since the money supply is smaller, the value of notes increases, which means that people can purchase more products or services using in exchange for smaller money spending. On the contrary, inflation occurs when the money supply in a country is increasing or available in a considerable amount.
Since there is so much money in circulation, the intrinsic value of the legal tender drops. As a result, people have to spend more money to purchase the same or smaller quantity of goods or services than before. It can seem like inflation is a real evil; however, it is interesting to note that deflation spanning over a larger period can drag the economy into stagnation. Since deflation can cause a Recession, therefore Central banks try to stop it from happening as soon as it arises.
What is Hyperinflation?
It is not possible to complete the discussion about inflation without talking about Hyperinflation. Usually, Capitalistic economic systems try to maintain a healthy, controlled, and consistent amount of inflation. However, in some cases, inflation can get out of control, and it means that the economy can suffer from its negative impacts. If the CPI (consumer price Index) shows an inflation growth rate greater than 50% per month, it means that the economy is suffering from Hyperinflation.
Hyperinflation can cause issues like an economic panic among the people. People can start hoarding goods in advance due to the fear of inflating prices. It results in increasing the demand to dangerous levels. Additionally, people can also refrain from storing their money in banks and other financial institutions that can bankrupt these institutions. At the same time, the tax revenues also drop. Government cannot provide any subsidies on essential goods for its citizens during inflation.
What is Disinflation?
Disinflation is also an economic term that is confused with deflation at times. Disinflation is the measure of periodic decline in the positive movement of inflation in an economic system. Disinflation is a tool to measure the rate of change or decrease in inflation over time. Therefore, it is a standalone term that should not be confused with deflation.
What is an Inflationary Cryptocurrency?
From the references above, it is clear that inflation and deflation are the direct product of macroeconomic properties of demand and supply. When an asset supply is going to increase in the future, it means that its unit value will drop. Therefore, people holding an inflationary currency will have to spend more in the future to purchase the same goods and services. In the same manner, the cryptocurrencies that have an unlimited or massive supply are inflationary tokens. Dogecoin is a good example of an inflationary asset.
Dogecoin founder removed the 100 billion Dogecoin supply cap in 2014. It means that Dogecoin now has an unlimited supply of tokens. Therefore, in the future, the supply of Dogecoin will keep increasing in the market.
It is worth noting that inflationary cryptocurrency supply can keep increasing in the market via the addition of new tokes, mining, staking, and other sources. When the supply of a total number of Dogecoins in the future keeps increasing, the intrinsic value of a unit Dogecoin will decrease, resulting in inflation for consumers.
What is a Deflationary Cryptocurrency?
In contrast to the inflationary cryptocurrencies, the supply of Deflationary tokens reduces or decreases from the main market over time. Therefore, the book value of the limited amount of cryptocurrencies left behind will increase since demand is greater in comparison to supply.
By understanding the differences between different types of cryptocurrencies based on their total supply mechanism cryptocurrency, investors can learn to arrange their portfolios more effectively. The Binance coin is a good example of a deflationary asset with a diminishing total supply.
BNB or Binance Coin that is native to the Binance Smart Chain or BSC sends a set percentage of tokens to burn addresses. A Burn address is a cryptocurrency protocol that removes the tokens from circulation permanently. BSC has implied this protocol to repeat and happen every quarter.
In the same manner, Polygon blockchain also sends its native coin MATIC to burn addresses periodically to reduce its total supply. Ethereum is a cryptocurrency with unlimited supply that has introduced a protocol in 2021 to turn the token into deflationary by sending a set of ETH to burn addresses.
Is Bitcoin an Inflationary or Deflationary Cryptocurrency?
When an unlimited or increasing supply of a cryptocurrency turns it into an inflationary token, the reverse is also possible. For a deflationary asset, the rules reverse in comparison to the inflationary asset class. It means that cryptocurrencies that manage or maintain their total supply in the future do not lose their value in the future.
Therefore, the consumers who are holding the deflationary cryptocurrency can purchase more from their unit token in the future. Bitcoin is a good example of a deflationary cryptocurrency. Bitcoin’s total supply is capped at 21 million tokens.
It is impossible for a cryptocurrency not to increase its circulation supply for a specific duration. Otherwise, the global and suitable distribution of the said token would not be possible. However, since the Bitcoin total supply can never increase from 21 million, it means that the market would never have an overwhelming or consistently increasing circulatory supply of Bitcoin in the future.
herefore, Bitcoin turns into a deflationary cryptocurrency. At the same time, Bitcoin has also included a halving protocol in the blockchain that cuts down Bitcoin mining rewards by half every four years. It is another way to maintain excessive Bitcoin supply in the market and preserve a high per unit book value.
What are Algorithmic Stablecoins?
It is important to discuss the algorithmic stablecoins when discussing inflationary and deflationary cryptocurrencies. Some blockchains act as Central Banks in the DeFi network by controlling the supply and demand of their native tokens. It is important to mention that stablecoins are cryptocurrencies with a stable or fixed unit price. They are not volatile like most cryptocurrencies and act like a placeholder for fiat currencies in the DeFi ecosystem.
Traditionally, stablecoins maintain their value by pegging the token with another asset such as commodities, cryptocurrencies, real estate, or even fiat currencies. However, Algorithmic stablecoins do not peg their tokens to any outside currency and act as Central Banks.
For example, TerraUSD or UST stablecoin is a good example. Terra network issues tokens that are directly attached to the value of the stablecoins or USTs. Terranetwork mints more tokens or burns them to maintain the book value of UST stablecoin always at $1.
The Unique Deflationary Quality of the XRP Token
XRP token that is native to Ripple uses a unique approach to make its unlimited token supply deflationary. The XRP ledger that is the direct issuer of the XRP tokens has released 100 billion XRP coins all at once. On the other hand, the same blockchain locked away around 55 million XRP tokens in 2017. Ripple Labs has told its investors that the locked away XRP tokens are set to release in the market to maintain the total supply on an ad-hoc basis and provide liquidity to the investors. At the same time, the users are required to spend a small portion of their XRP reserves as gas fees when they are making any transactions on the XRP Ledger. Ripple labs use the tokens collected as a transaction fee and send them to burn addresses to reduce their total supply and thereby becoming a deflationary asset.
Key Features of Inflationary and Deflationary Cryptocurrencies
When it comes to measuring the inflation or deflation of fiat currencies, it can take a complicated and detailed economic analysis to determine it. However, for cryptocurrencies, certain factors provide a simple and easy option for measuring the inflationary or deflationary nature of the token in question. At its core, when the total supply of a cryptocurrency keeps increasing, it means that that token is an inflationary cryptocurrency.
On the other hand, when the total supply of a token reduces over time, it means that the said cryptocurrency is deflationary. At its core, some other factors can help cryptocurrency investors to determine whether a cryptocurrency is deflationary or inflationary by nature. Here are some of the most important factors that will help the reader in making the correct assessment:
Capped Amount
Capped amount of a cryptocurrency plays an important role in making the asset an inflationary or deflationary asset. If the maximum supply of a cryptocurrency is capped at a fixed amount, it is more likely that the token is deflationary. For example, the maximum supply of Bitcoin is capped at 21 million, which means that the total number of Bitcoins can never increase. Therefore, Bitcoin is deflationary by default.
Circulation
The circulation supply of a cryptocurrency can also make a huge difference in making it inflationary or deflationary. Therefore, some blockchains have an infinite supply of their tokens; however, they have put such protocols in place that are used to decrease the total circulatory supply of the said token. Therefore, when determining the inflationary or deflationary nature of a cryptocurrency, cryptocurrency investors should also consider the circulatory supply.
Aggregate Supply
The total supply of the overall blockchain also has an important impact on the inflationary or deflationary nature of cryptocurrencies. To this end, if from the point of their first token issue to the point of their last token issue is consistently increasing or decreasing, it means that the said cryptocurrency can also be inflationary or deflationary simultaneously.
Differences Between Inflationary Deflationary Cryptocurrencies
Thus far in the article, all the basic working and concepts of inflation and deflation were discussed in detail. Now, it is time for investors to learn about the key point of distinction between inflationary and deflationary cryptocurrencies. One should keep in mind that they should read about the comparison of inflationary and deflationary cryptocurrencies with a view of their advantages and disadvantages. Here are some important comparative factors that cryptocurrency investors should keep in mind while analyzing:
Supply of Tokens
The supply of tokens is a very important part of determining if a cryptocurrency is inflationary or deflationary. When the supply of a cryptocurrency keeps increasing over time, it means that the asset is going to be inflationary. It means that over time the cryptocurrency in question is likely to experience a drop in demand on account of its increasing quantity. In other words, it is also correct to state that inflationary currencies offer higher supply in comparison to their demand at any given time.
On the contrary, deflationary cryptocurrencies are smaller in number, and they keep decreasing their supply over time. It is also important to note that these cryptocurrencies can also have an infinite supply but still manage to become deflationary on account of protocols like burning addresses. In other words, deflationary assets offer consumers a token supply that is smaller in comparison to its demand in the marketplace.
Power to Purchase
Since the supply of the inflationary tokens is going to keep increasing over time, it means that their demand will drop. When any product is available on the market in large quantities, it is readily available, and people are not worried about finding this product anymore. Consequently, the value of the product drops. Likewise, when the supply of inflationary cryptocurrencies increases, their value drops and the purchasing power of the users declines.
On the flip side, deflationary cryptocurrencies aim to reduce their supply as time passes. It means that if there are many tokens available in the market today, in the future, the total number of the same tokens is going to drop. Therefore, consumers will try to look for these tokens, and their demand will increase. In the same vein, the prices of these deflationary assets will increase. Therefore, the purchasing power of the people who are holding said tokens will also improve.
Intrinsic Value
In the case of inflationary assets, the blockchain or the private company that issued these tokens encourages people to spend more. In this way, the supply in the market for the said token can remain higher in comparison to its demand. When investors have a cryptocurrency with some value and its quantity increases in the market, it is going to lose its value. Therefore, investors with inflationary crypto currencies want to spend it all ASAP before its value drops any further.
On the other hand, the people who are working with deflationary assets try to hold on to them for a longer duration. By default, the supply of deflationary assets in the market is going to keep growing smaller. Therefore, as long as the cryptocurrency investors can hold on to the deflationary assets, they can make more profits. Therefore, in most cases, investors like to hold their deflationary assets for longer durations.
Conversion
It is possible to convert a deflationary asset into an inflationary asset by making its supply unlimited. In the case of blockchains like ETH and Dogecoin, the same is true. When a cryptocurrency has a limited supply, it means that with time its demand is going to keep growing, but the number of the token will remain the same. Therefore, the supply will start to shrink in comparison to the demand.
At the same time, cryptocurrencies can also become deflationary if supply control protocols such as mining reward halving and burn addresses are removed from the blockchain. In the same manner, it is also possible to covert an inflationary asset into a deflationary one by limiting its supply and introducing options like burning and halving mining rewards.
Conclusion
It is very important to learn about inflationary and deflationary forces in the cryptocurrency market regarding economic impact. The study of economics is essential for all financial investors who wish to master the art of making profits. By learning the dynamics, factors, and key factors around inflationary and deflationary cryptocurrencies, the investors can make the best decisions and know the best time to hold or sell their cryptocurrency reserves.
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