Explaining Inflationary and Deflationary Cryptocurrencies – A Complete Guide

Inflation is causing dominant impacts on the purchasing capacity of crypto assets worldwide. It also affects the trading decisions of traders and buyers in the financial market. Due to inflationary impacts, the buyers require more money or fiat currency to purchase the same item. Although inflation may have adverse effects on the market, it may also prove helpful for the market as it may encourage the betterment of the economy.

Ordinary people thoroughly understand inflation as it has several impacts on the fiat currencies and their purchasing power. However, inflationary and deflationary cryptocurrencies are still new concepts to them. This article will explain the concept and difference between inflationary and deflationary crypto assets. Moreover, they will also learn the nature and impact of different crypto assets in the market.

What is an Inflationary Cryptocurrency?

As the supply of coins increases, some currencies become inflationary in behavior. A combination of supply constraints, multiple mechanisms for the distribution of tokens, and predetermined inflation rates are utilized by inflationary cryptocurrencies. It also helps provide incentives to the participants and maintenance of the network’s supply chain.

Cryptocurrencies have multiple mechanisms for creating and supplying coins in the market depending on the monetary systems. When an inflationary cryptocurrency enters the market, the supply of coins steadily increases.

The percentage increase in the cryptocurrency’s total supply is specified by the rate of inflation set before time. In addition, the maximum supply of the inflationary token is usually fixed. However, in some cases, it may vary by defining the total count of the tokens to be created. One cannot mint more tokens if the maximum limit set initially is reached once.

However, the fluctuating tokenomics of multiple currencies can be adjusted accordingly. In 2014, Dogecoin (DOGE) faced a hard cap of about 100 million tokens, later removed by a supply cap. This decision led to an unlimited supply of Dogecoins in the future.

Working of Inflationary Cryptocurrency

Multiple consensus mechanisms, such as Proof of stake (PoS) or Proof of work (PoW), are used by inflationary cryptocurrencies. They distribute newly minted coins among the participants of the network. As a result, new coins are either distributed among the network’s validators, such as Ethereum, or mined into existence, such as Bitcoin.

The transactions held on the network are validated by miners using Bitcoin’s Proof of Work consensus. The one who figures out the puzzle first wins the reward on the network. On the other hand, in the Proof of Stake protocol, a validator node is chosen to review the block after the transaction block is ready to be reviewed. For this purpose, the block is added to the blockchain, and the validator receives a reward for contributing to the block.

The validator checks the accuracy of the block transactions. The block is then added to the blockchain, and in return, the validator receives an Ethereum reward equivalent to the stake ratio of the validator.

Primarily, governance issues also influence the distribution of many cryptocurrencies. The inflation rate of any currency and the distribution of currency might be affected by the voting of the DAOs. They might want to change the vesting periods, staking rewards, and release the treasury funds.

What is a Deflationary Cryptocurrency?

As the supply decreases, the deflationary cryptocurrency deflates over time. Deflationary tokens use several mechanisms to reduce the supply. The coins are also destroyed by coin burning and paying the transaction costs.

The deflation cost of the deflationary cryptocurrencies is determined before time. The decrease in the total supply of the currency over time is determined by the rate. The deflation rate of cryptocurrency is about 2.5% per year. Therefore, the supply of the currency decreases by 2.5% every year.

The maximum number of tokens to be created is also limited, as the deflationary crypto assets may have a limited or variable supply. As the supply limit is reached, no one can make mint new coins. However, the stakeholders holding the incentives, such as users, developers, and miners, decide the economics of deflationary crypto assets. The supply and demand phenomenon of these currencies is also affected by these stakeholders’ changing goals and aims.

Miners hold the new coins in a bull market after mining them instead of selling them in the financial market. Therefore, in the case of DOGE, the supply caps are removed, and the crypto assets become vulnerable to scams.

Working of Deflationary Cryptocurrencies

Deflationary cryptocurrencies use several direct and indirect mechanisms to destroy coins being circulated in the market. In some cases, deflationary coins use transaction costs that assist in the burning process. As a result, it decreases the total number of coins available in the market.

A specific amount of coins are also deleted from the market circulation by sending them to an inaccessible address through coin burning. BNB reduced half of its supply in the market by adopting two coin-burning mechanisms. At first, half of the BNB is burnt as gas costs on the network, and the rest is then deleted in burning events.

Another strategy used by deflationary cryptocurrencies to decrease their token supply is halving. The mining rewards earned by the Bitcoin miners are cut to half every four years, thus causing an impact on the scarcity of Bitcoin.

Factors Deciding the Inflationary or Deflationary Economics of a Currency

It might become perplexing for an ordinary person to understand crypto assets’ inflationary or deflationary nature. The cryptocurrency that allows the continuous growth of a crypto asset is termed inflationary. The one whose token supply decreases with time is known as a deflationary cryptocurrency.

The three crucial economic factors that decide cryptocurrencies’ inflationary or deflationary nature are discussed below.

• Maximum Supply

Usually, a hard cap is put on the maximum number of tokens that can enter into circulation in the financial market. Bitcoin has limited the total number of tokens to a maximum of 21 million.

• Circulating Supply

The total number of crypto assets linked with a specific blockchain determines the circulating supply. The circulating supply of any cryptocurrency is the most important decisive factor in deciding its inflationary or deflationary nature.

• Total Supply

It is the total supply of a specific crypto token. The total number of coins mined on the blockchain network is also included in the total supply.

Inflationary Cryptocurrencies vs. Deflationary Cryptocurrencies

The supply mechanisms and monetary policies differ for inflationary and deflationary cryptocurrencies. The usage and value of each cryptocurrency are greatly affected by these distinct qualities. The tokenomics for both kinds of cryptocurrencies are different.

The total coin supply limit for deflationary crypto assets is usually fixed. It results in increasing the purchasing power of the coin with time. On the other hand, the purchasing capacity of inflationary cryptocurrencies increases with time as the coin creation capacity is usually flexible.

However, there are certain benefits provided by inflationary cryptocurrencies as compared to deflationary ones. It discourages its buyers from hoarding and stocking currencies and incentivizes them to spend them in the market.

Moreover, it may also help increase the currency’s liquidity and help the users adopt it rapidly depending on its application. The functionality and usage of the currency decide the medium of exchange.

Therefore, the monetary policy offered by inflationary cryptocurrencies is more flexible than many fiat and deflationary currencies. The ecosystem’s needs can be met by adjusting the inflation requirements of the currency, such as providing incentives for participation, developing funds, and minimizing the inflationary pressure from the fiat currency mechanisms.

On the other hand, in deflationary cryptosystems, users are provided incentives for stocking and hoarding their assets. It discourages traders from spending the crypto holdings in the market. It helps adopt the currency as a store value and decreases its availability in the market.

Moreover, deflationary cryptocurrencies provide a barrier against stagflation, hyperinflation, and inflation in the market. It preserves the value of the currency with time. The inflationary pressure of the currency caused by economic events and governance policies is minimized by the decrease in the supply of tokens in the financial market.

A few key differences between inflationary and deflationary cryptocurrencies are mentioned below.

• Usage

Traders are encouraged to spend and utilize inflationary cryptocurrencies in everyday transactions. On the other hand, in deflationary cryptocurrencies, traders are provided incentives for storing them as they provide a barrier against market inflation.

• Supply Dynamics

The governance mechanism and protocol decide the flexible or fixed token supply in inflationary cryptocurrencies. However, the supply dynamics in deflationary cryptocurrencies are fixed, but it also depends on the governance policies and protocols.

• Stability

The monetary policy for inflationary crypto assets is permanently fixed. However, deflationary crypto assets may cause an increase in the unavailability and adoption of the token with time.

• Incentives

The users holding inflationary cryptocurrencies are incentivized if they spend it in the market. Whereas traders dealing with deflationary cryptocurrencies are encouraged to stock them and earn rewards.

• Preservation of Value

The value of inflationary cryptocurrencies is usually adjusted to match the needs of the consumers. On the other hand, deflationary crypto assets provide a barrier against hyperinflation and inflation in the market.

• Purchasing Power

The purchasing power of inflationary crypto assets may increase or decrease with time. Similarly, the market needs and scenarios decide the increase or decrease in the purchasing power of deflationary crypto assets in the financial market.

Is Bitcoin an Inflationary Cryptocurrency or Deflationary?

Several factors decide the inflationary or deflationary nature of Bitcoin. As new coins are continuously supplied in the market after mining, one may consider Bitcoin an inflationary cryptocurrency. However, the inflationary pressure is also reduced by several techniques, such as halving, making it a deflationary currency.

The supply of Bitcoin is limited in the market, incorporating the deflationary measure known as halving. It justifies the deflationary nature of Bitcoin. It reduces the reward percentage for the participants. Moreover, it may also cause impact the scarcity of Bitcoin and help minimize the inflation in the market. However, mining Bitcoin is becoming highly costly and challenging as the reward decreases with time.

Bitcoin has placed a supply cap of about 21 million. It means no more coins are added to the financial market once thoroughly mined. It is expected that by the year 2140, the hard cap of Bitcoin will be reached. There will be no new coins added to circulation as inflation will decrease.

However, as Bitcoin’s external demand and deflationary mechanics increase, its adoption and demand also increase in the financial market. Moreover, it may also cause an increase in the price of the coin. The internal mechanics of Bitcoin may provide a barrier against inflation in the market, thus helping reduce its price.

Is Ether an Inflationary Cryptocurrency or Deflationary?

Ether’s inflationary or deflationary nature is still discussed among experts. The absence of a hard cap on the supply of Ether in the market is a justification provided by the ones supporting the inflationary notion. However, the deflationary trend is justified by the ones who present the idea of programmed minimization of ETH token creation, the Proof of Stake protocol, and the increased applications of ETH in the decentralized finance sector.

Many decentralized applications (DApps) are created through the Ethereum ecosystem. The transactions over the network are carried out through the local currency of the Ethereum network, known as Ether. Moreover, it is also presented as a reward to the network participants. Creating new ETH coins is predicted to decrease with time, although no fixed limit is set on the total supply of Ethereum tokens in the financial market.

The amount of ETH issued yearly was about 5% before the Merge happened. Therefore, about 5% of new ETH tokens were added into circulation each year. However, when it shifted to the Proof of stake protocol, it decreased the token issuance as a reward. This resulted in making the ETH a deflationary asset.

Moreover, the validators should stake the ETH tokens as the Ethereum protocol now uses the Proof of stake consensus mechanism. The supply of ETH available for trading might decrease as more ETH gets locked in the system. This also leads to a decrease in the token’s price in the financial market.

In addition, the users who agree to the deflationary argument of Ethereum may take a stand for its adoption and utility in the market. As the number of decentralized applications created on the network increase, it will proportionately increase its price and demand.

 Moreover, the demand for Ethereum as collateral and means of payment will also increase as decentralized applications are created through the Ethereum network. This will ultimately also cause an increase in the price of the token.

Some Common Inflationary Cryptocurrencies

Most of the cryptocurrencies available in the market are inflationary. The highly volatile nature of crypto assets ensures traders invest for a shorter period to avoid significant losses. A few inflationary cryptocurrencies are discussed below.

• DOGE

According to market capitalization, Dogecoin is considered the seventh largest cryptocurrency. It is adopted by many digital users raising the token’s value rapidly. The coin does not have any mechanism to control inflation. The popularity of the coin is expected to decrease with time.

• FLOW

FLOW is the local token of the Flow blockchain network. The coin supports multiple forms of entertainment, including gaming. It provides great ease to the developers and users in the market. The demand for FLOW is increasing as it completes many network functions. FLOW owns specific mechanisms to minimize inflation but cannot eliminate it.

• DOT

Polkadot supports the creation of decentralized applications; therefore, it has been adopted by several users. Moreover, it does not require any mediator to execute transactions. It provides sufficient scalability and interoperability to the network.

Some Common Deflationary Cryptocurrencies

Traders usually adopt deflationary crypto assets for making long-term investments. This is due to the limited supply of tokens in the market, increasing their value with time. A few of the deflationary cryptocurrencies are discussed below.

• XRP

XRP is the local token used for the Ripple network. It has a particular consensus mechanism to carry out transactions instead of mining. The network has a lower transaction fee and ensures fast execution of transactions.

• MATIC

Polygon helps in developing connections among various blockchain networks. Like the Ethereum network, it also uses a Proof of stake consensus mechanism to complete the transaction procedures. The native token of the network is MATIC which is used for paying the fee and staking crypto on the network.

• BNB

Binance Coin is a crypto exchange that allows users to trade cryptocurrencies. It limits its supply of tokens on the network. Every transaction on the network creates a gas fee to support the activities carried out on the network.

Conclusion

Whether a cryptocurrency is inflationary or deflationary provides many insights to the users about the market mechanics. Depending on the demand and supply phenomenon of the market, cryptocurrencies change and fluctuate accordingly. However, it provides a clear notion that a currency’s purchasing power and value are determined by its supply in the market.

However, the users should keenly notice the mechanisms involved in deciding a crypto asset’s inflationary and deflationary nature and learn about the risks involved with them thoroughly to avoid any loss in the future.