Inflationary vs Deflationary Tokens: How do they affect the crypto market?
What is the difference between inflation and deflation?
Inflation and deflation are well-known economic terms that illustrate a change in the price level of goods and services in the entire economy over a certain period of time. These concepts are significant within traditional finance so let’s explain them briefly.
Inflation refers to a quantitative measure of how fast the prices of goods in a particular economy are increasing. It typically happens when goods and services are high in demand; supply drops, and prices go up.
On the other hand, we are talking about deflation when there are too many available goods or services or when there is not enough money to purchase them. Consequently, the price of goods and services goes down.
Inflation is a bad word in traditional economies; it causes stagnation in wage growth while also stimulating the price rise. Now that crypto assets are in the picture, the inflationary vs deflationary cryptocurrencies debate has become more popular. Many people believe that cryptocurrency can provide an alternative way to hedge against inflation risks.
To find out which issues can cause creating more fiat money in traditional financial systems, we suggest reading this article: 'What does money printing really mean?'.
An element in common
Did you notice that the common trait in explaining both inflationary and deflationary currencies comes down to supply?
Fiat currencies tend to be inflationary since it is possible to increase their supply, yet deflation refers to a reduction in demand and increase in supply which then amounts to a higher purchasing power of the fiat currency. Let’s check out how the inflation and deflation concepts fit into the crypto space.
What does it mean in the crypto space?
Inflationary and deflationary traits of cryptocurrencies are opposite sides of the same coin.
Inflation consists of increasing cryptocurrencies in circulation; as a consequence, the purchasing power of a cryptocurrency unit decreases over time due to an increase in the prices of goods. On the other hand, deflationary cryptocurrencies include a limited amount in circulation which typically remains the same. As a consequence, the purchasing power of a currency unit increases.
Even though inflation and deflation are basic concepts, they are important for navigating the cryptocurrency market successfully. In this article, we will teach you about key features and differences between inflationary and deflationary cryptocurrencies as well as the main economic factors behind these concepts.
When getting into the crypto space, education is a must. If you are looking where to start, check out available courses on our Learn Crypto Academy.
What are inflationary cryptocurrencies?
If we take a look at crypto monetary structures, we can see that there are various supply mechanisms. Divergent cryptocurrencies have varying tokenomics – however, inflationary cryptocurrencies are associated with an increase in supply over time.
An inflationary cryptocurrency typically includes a steadily increasing supply entering the crypto market, along with a predetermined rate of inflation. Its maximum supply is fixed or variable, setting out the number of tokens that can be created over time. Once a maximum supply of tokens is reached, no more can be created.
Some common ways to put new tokens in circulation is through mining, staking or other activities. A token’s increased supply causes a drop in value, and users have to spend more tokens to buy a certain product.
Inflationary tokens can be a good thing for users looking to use cryptocurrencies for their everyday transactions since the low value of coins means that transactions can be conducted with small amounts. On the other hand, keep in mind that the constant creation of new tokens can lead to inflation and a broader decrease in value over time.
What are deflationary cryptocurrencies?
A deflationary cryptocurrency is one where the supply of coins decreases with time. In the case of consistent demand, the value of tokens should increase. We say that deflationary cryptocurrencies deflate over time due to decreased supply.
Crypto projects employ deflationary mechanisms to diminish their supply such as destroying tokens through burning and transaction fees. They tend to use unique mechanisms for specific objectives.
Deflationary tokens usually include a predetermined deflation rate laid down in the protocol which establishes the percentage decrease of the token’s total supply. For example, a token has an annual deflation rate of 2%.
It is important to mention that the economics of deflationary tokens is mainly impacted by stakeholders’ incentives as well as those of miners, users, and developers.
How does a deflationary cryptocurrency work?
When the set supply of tokens for a deflationary cryptocurrency has been released, no more tokens can be created. As the demand increases, users and investors need to pay more because of its limited supply.
As mentioned above, some deflationary tokens utilise transaction fees to burn tokens and reduce their number in circulation. The burning method can also include sending a determined amount of tokens to a particular inaccessible address which removes them from circulation as well.
For example, BNB uses two burning mechanisms to cut its supply in half over time; the first one refers to burning an amount of the tokens spent as gas fees on the blockchain, and the second one includes frequent token burning events.
It is interesting to note that Ether was an inflationary cryptocurrency but the network update converted it into deflationary crypto by burning tokens from its circulating supply.
On the other hand, Bitcoin utilises halving events; every four years, the halving event cuts the mining rewards to affect the cryptocurrency’s scarcity.
What are the key differences between inflationary and deflationary cryptocurrencies?
We have already pointed out that supply is the common element of both inflationary and deflationary cryptocurrencies – the economic systems display divergent supply dynamics and these differences impact each asset’s value and overall utility.
When talking about utility, inflationary cryptocurrencies are used more as a medium of exchange as they provide a more rapid adoption and higher liquidity. The inflation rate can be controlled by its monetary needs such as encouraging user participation and funding technological innovation. Simply put, those looking to use cryptocurrencies for everyday transactions are more in favour of inflationary cryptos.
On the other hand, deflationary cryptocurrencies are all about increasing scarcity and the asset’s status as a store of value. Therefore, they promote hoarding and can also be used as a protection tool from inflation. Their decreasing supply can be used to diminish the negativity of outside elements such as economic developments or regulatory changes.
Keep in mind that both inflationary and deflationary cryptocurrencies have their advantages and disadvantages. Learn to spot the difference and use them both for your benefit.
Supply and demand
The supply structure of deflationary and inflationary tokens is the opposite; a deflationary cryptocurrency has a fixed token supply while an inflationary cryptocurrency encompasses a floating or unlimited supply.
The notion that supply is floating or fixed affects the interplay between supply and demand. For example, a floating supply increases over time and keeps up with demand. The outcome is a token price that is not dominantly driven by the laws of supply and demand.
On the other hand, a fixed cryptocurrency's supply causes pressure on the value of deflationary tokens since demand increases over time but there might not be enough tokens to meet that demand.
Conversion
Another important element of this comparison refers to the flexibility for conversion of inflationary to deflationary assets. The inflationary vs deflationary crypto debate needs to find an answer on how inflationary tokens can convert into deflationary ones for a limited period.
For example, cryptocurrencies utilise divergent mechanisms – some include a burning mechanism to control the supply in times of high demand while others destroy tokens to maintain stability such as stablecoins. Others charge transaction fees to minimise inflation.
Purchasing power
The purchasing power of inflationary and deflationary crypto assets is another key point in this comparison. Generally speaking, the value of inflationary cryptocurrencies diminishes over time since more tokens are being released – when the value of the inflationary cryptocurrency goes down, the purchasing power drops accordingly.
The value of deflationary tokens increases over time due to demand driving the tokens’ value up. Consequently, the purchasing power of these tokens increases.
Is Bitcoin inflationary or deflationary?
To state whether Bitcoin (BTC) is an inflationary or deflationary cryptocurrency depends on several factors. It can be considered inflationary since new coins are being mined to enter the circulating supply, yet it encompasses certain deflationary mechanisms such as halving.
Most people think that Bitcoin is a deflationary crypto because it has a limited supply with a hard cap of 21 million coins set in place. This means that when all coins are mined, no more Bitcoins will be added to the cryptocurrency market. Once the hard cap is reached, inflation should cease to exist.
Bitcoin’s deflationary mechanism is based on halving events that cut rewards for miners and thereby, affect the cryptocurrency’s scarcity and reduce inflation over time.
How do inflationary and deflationary cryptocurrencies affect the crypto market?
When it comes to the economic impact, inflationary tokens prioritise stability due to the continuous growth of supply and the ongoing perception of predictability for the token holders. However, take into account that the economic impact of each crypto project is linked to its objectives and user base.
On the other hand, deflationary tokens present a scarcity value – they attract users and investors that seek the possibility of price appreciation.
Therefore, inflationary tokens attract those who seek a continuous sense of stability while deflationary ones are more for those looking for assets with limited supply and price appreciation potential. Each user’s perception is based on their individual risk tolerance and investment strategy.
How do these tokens affect liquidity in the crypto market?
Inflationary and deflationary token models have distinct impacts on market liquidity, influencing the supply and demand dynamics within a cryptocurrency ecosystem. Let’s delve into the details of each.
These tokens affect market liquidity differently. When talking about inflationary tokens, it can be said that the continuous release of new tokens can increase market liquidity. More tokens usually equals more possibilities for crypto trading which can diminish the occurrence of broad price movements.
Deflationary cryptos, on the other hand, are more scarce. This amounts to an increased value of deflationary tokens but it can also reduce liquidity on the crypto market. Scarce assets are less available for trading and susceptible to higher price volatility.
Token model design
Both inflationary and deflationary token models can affect market liquidity. Therefore, some crypto projects tend to create a balanced token model to provide a solid level of liquidity and suit the crypto market dynamics.
Some opt for a horizontal token model that is neither inflationary or deflationary by keeping the token supply at a steady level. They determine the token supply at the beginning of their crypto project and don’t alter it later.
A horizontal token model can ensure a stable value of the token and obtain the users’ trust since they know the token’s supply in advance based on criteria laid down in the very beginning. This trait reduces uncertainty in the volatile crypto market.
On the other hand, horizontal token models can limit the potential growth and further development of the token since the token supply is not flexible enough to adapt to changing market dynamics.
Secondly, some crypto projects implement an elastic token model which refers to a mechanism that automatically changes its supply. Simply put, when the demand increases, supply increases and vice versa.
The elastic model is more suited for the changing conditions on the market and the interplay between supply and demand. However, this model can be complicated to implement and properly maintain as it can lead to sudden price fluctuations.
These models present divergent approaches that affect market liquidity. They have their sets of advantages and disadvantages; when designing a token model for your crypto project, it is important to choose the appropriate one depending on the project’s main objectives and use cases.
The bottom line
As we have already established, the key difference between inflationary and deflationary token models lies in their supply and utility. Inflationary assets are used for everyday transactions while deflationary assets attract long-term investors.
Inflationary and deflationary assets both influence the dynamics of market liquidity and include their unique sets of upper-hands and drawbacks.
Users need to weigh the risks and rewards associated with both models based on their needs, risk tolerance and investment objectives. Understanding the implications of both models is significant for any users in the crypto ecosystem.