What Is Deflationary Cryptocurrency?

Savvy buyers seek out deflationary cryptocurrency for the economic safeguards it provides. These benefits complement cryptocurrency’s inherent ability to hedge against economic downturns. By definition, deflationary cryptocurrencies describe tokens limited in supply but high in demand. These cryptocurrencies are not minted, mined, or staked on a whim.  

Deflationary cryptocurrency relies on a decreasing supply of a particular token on the blockchain. This, in turn, increases the purchasing power and value of each unit. So long as demand remains high, deflationary tokens return at a higher rate and increase in value. Some deflationary cryptocurrencies maintain a set supply limit while others may decrease the supply via destructive methods to protect token value.

Inflation vs. Deflation

These two terms describe the relationship between an asset and its purchasing power, reliant upon supply and demand of both the asset and the item being purchased. Inflationary conditions exhibit increased production of a currency based. As the supply of such a currency increases, the purchasing power per unit of that currency decreases in value. 

The opposite proves true for deflation, where supply limits dictate value. With less to go around, these holdings increase in per-unit purchasing power, so long as the demand remains consistent. As such, deflationary currency relies on a one-to-one exchange, whereas an inflationary currency exists within a floating system of value. 

Unlike fiat currencies, cryptocurrency holdings do correlate to specific tokens. To call these digital tokens tangible would be a stretch, but they are still limited through an immutable smart contract. As the number of tokens available increases and the value represented by the sum of the tokens stays the same, cryptocurrencies become inflationary. Conversely, deflationary cryptocurrencies exhibit a decreasing or constant supply with constant or increasing value. 

Inflationary vs. Deflationary Cryptocurrency

Differentiating between inflationary and deflationary cryptocurrency requires inspecting the origination of new crypto tokens, specifically how they come to market. Consider a few of the most popular cryptocurrencies to begin to understand whether they are inflationary or deflationary now. 

Miners and minters increase the supply numbers of inflationary cryptocurrencies. This, in turn, increases the supply of the token. So long as the demand supports a profitable relationship, inflationary cryptocurrencies can provide benefits as well. For instance, Dogecoin was deflationary before 2014, when creators removed the cap on this cryptocurrency. Bitcoin remains limited in supply at 21 million tokens. 

Deflationary cryptocurrencies such as Binance, Ethereum, and Ripple represent tokens that limit their supply. Collectors prefer these deflationary cryptocurrencies like any other limited asset, as they have a higher potential to prove profitable soon. They’re the cream of the proverbial cryptocurrency crop.  

Economic Principles of Cryptocurrency Inflation and Deflation

The following five principles of economic inflation and deflation characterize both inflationary and deflationary cryptocurrency holdings. 

Fixed or Floating Value

Assets maintain either a fixed or floating value when compared to other commodities. For instance, traditional currencies correlate to gold and other commodities like crude oil. This physical, material good regulated the currency, unlike floating-value currencies.  

Fiat currencies exemplify the principles of floating value, wherein the printed currency retains value based on an agreement of all parties involved. This type of currency maintains no upper limit, which tips the scales in favor of supply over demand and resulting inflation. 

Supply and Demand

Both inflationary and deflationary cryptocurrencies command contrasting ratios between supply and demand. Inflationary cryptocurrencies must be high in supply but not matched in terms of demand. Conversely, deflationary cryptocurrencies favor a low supply and yet a high demand. 

Conversion from Inflationary to Deflationary

Cryptocurrencies transition from inflationary to deflationary throughout their lifecycle. Most of these alternative currencies begin as inflationary. This is not always the case. Yet, while inflationary cryptocurrencies may settle into a deflationary stage, they cannot return to their inflationary status thereafter. 

To prove this arc from inflationary to deflationary, consider Ethereum. This cryptocurrency asset was once inflationary as Ether tokens flooded the market. Recently, however, Ethereum developers began to reduce the overall supply through a process known as “burning.” Ethereum developers destroy tokens at a rate that correlates with keeping Ethereum within deflationary limits. 

Comparative Value

Deflationary cryptocurrencies may prove more profitable at first glance in contrast to inflationary cryptocurrencies, but there’s more to this dynamic than meets the eye. For instance, deflationary currencies retain an increasing value only when demand is high. When the demand fails to support a price increase and justification for the scarcity, a deflationary cryptocurrency can experience quite a few things. 

One of the most notable consequences of a loss of demand is the influence on the value of the once-deflationary cryptocurrency. This process mirrors any commodity on the market. When an asset’s demand tapers, so too does the value. Yet, cryptocurrency does have the unique ability to hedge against even this downfall by providing value in correlation to other commodities and assets. This, in effect, broadens the value proposition further to retain a high demand. 

Purchasing Power

The purchasing power of cryptocurrency can describe the relationship between value and quantity. Deflationary cryptocurrencies that are high in demand and low in number command more purchasing power. Even as cryptocurrency vacillates between high and low purchasing power, it’s important to keep in mind that these values can change in response to how many tokens are available at any given time. Inflationary cryptocurrencies may be available, but this decreases their value. Deflationary cryptocurrencies tend to dwindle in number and increase in value as time goes on. 

Conclusion

Both inflationary and deflationary tokens can be used for different purposes; however, many new projects are tending towards deflation. Deflationary and inflationary characteristics are only one small piece that financial professionals need to consider when evaluating a token. The Wharton School created the Economics of Blockchain and Digital Assets course to help financial professionals navigate the new environment created by blockchain. ​​The blockchain certification course features more than 80 videos, seven industry-leading case studies, three crypto valuation models, and more. For more information on the program or to enroll, visit our information page to learn more.

This article is for marketing purposes only and does not intend to represent the opinions of the program.