Since the term “inflation” can often cause confusion, let’s start by explaining the different definitions of the word “inflation”, and determine how it differs in the traditional financial and cryptocurrency industries.
In general, in all its definitions, the word “inflation” is synonymous with the expansion of the concept. Applied to finance, it refers to the money supply.
You need to start by looking for an answer to the question of what inflation is in traditional finance.
Economists use the word “inflation” in traditional finance to describe the rising cost of living. Most economists argue that a small annual inflation is healthy. However, if we consider what inflation is and how it occurs, we will understand that too high inflation can be disastrous. Let’s briefly look at how inflation occurs and why it continues to grow recently.
When calculating the cost of something, you need to remember two key things: supply and demand. In the case of a fiat currency, a vital factor determining its value is the degree of trust in the government of the country. By themselves, the pieces of paper have no value. Rather, the trust between the parties that the paper has equal value in exchange for a good or service supports consumer spending. Until 1971, the US dollar was pegged to one troy ounce of gold. Moreover, then other world currencies were backed by the US dollar. However, President Nixon shamefully lowered the dollar’s price peg, and most fiat currencies, in turn, had no reinforcement in the form of any tangible assets.
Therefore, it is often better to consider inflation not as an increase in the cost of goods, but as a decrease in the value of the currency and its purchasing power. While the supply of currency is increasing thanks to “quantitative easing” (QE), the issuance of six- or seven-figure loans to “zombie” enterprises and attempts to stabilize the economy with the help of a global pandemic, demand (population) is almost unchanged. The main ingredients of Coca-Cola have not changed either. However, fifty years ago it was possible to buy five cans for $0.50, now it takes on average more than five times more ($2.50) to buy one can. The main ingredients of the product are no different. Instead, the value of the currency the product is bought for costs less, so you need more currency to buy the same amount of product.
How to Understand Cryptocurrency and Inflation
So, now that we understand how inflation works in the traditional financial sphere, let’s study the relationship between cryptocurrencies and inflation. Firstly, there are two ways to estimate inflation in the cryptocurrency industry.
You can consider the inflationary aspects of the distribution model of a cryptocurrency coin or token. Alternatively, you can consider investing in cryptocurrencies to hedge against inflation. The form of the token distribution model is of fundamental importance for the deflationary aspects of the project.
The Western capitalist economic model assumes a free market, where the value of assets is determined by their availability (supply) and stimulation of consumer spending (demand). However, in traditional markets, governments often intervene to offer loans (print more money/expand the supply of currency) to businesses living in debt but “too big to fail”.
Accordingly, the destruction of unprofitable business models and the redistribution of assets in favor of promising innovative business does not occur. However, in the crypto industry, investors can freely trade, buy and sell assets at their discretion without centralized price manipulation. That is why a calculated distribution model is vital for the value and durability of a crypto asset.
The token distribution model of the project can say a lot about the legitimacy and durability of the project. The rate at which new coins or tokens enter free circulation on the market is known as the “inflation rate”. In addition, there are several points to consider.
First, projects can offer a private sale or seed round by selling their own tokens to finance the project. In addition, project tokens could be immediately released to team founders, advisors, developers, etc. Also, tokens could be allocated as a reward for community incentives.
Secondly, the speed of new tokens entering circulation may affect its price. Cryptocurrency marketing campaigns, including airdrops and giveaways, mean that certain community members will receive free tokens of the project before or during the launch. Projects should be careful not to give away too much so that holders can potentially sell their assets after launch, which will reduce their value. Moreover, the percentage of the distribution of project tokens available to developers is another feature that should be taken into account. Historically, there have been “pumping and dumping” schemes in projects. In such cases, after a successful launch, the developers sold their control packages of tokens. Thus, several people can leave with millions, and investors are left with worthless tokens.
Distribution of cryptocurrency tokens
The distribution models and the inflation rates of tokens vary greatly in different projects. Some projects encode long-term distribution for many years. Others issue all tokens during the first year, without a seed round or team holdings. This is often an attempt to show the focus of the project on the community and its development.
Do cryptocurrencies protect against inflation?
So, one of the ways to consider cryptocurrencies and inflation is the project’s token distribution model and the inflation rate. Another way to consider the topic of cryptocurrencies and inflation is to study the question “do cryptocurrencies protect against inflation?”. In short, some crypto assets are protected, and some are not. This largely depends on the asset distribution model, the value and acceptance of the project, and, ultimately, on the value of the US dollar.
According to Coinmarketrate. com, the first cryptocurrency in history, Bitcoin, was conceived as a deflationary asset. Simply put, this means that as the value of traditional currencies decreases, the value of Bitcoin will increase. This process is sometimes called “inflation hedging”. Many people living in countries with unstable economies and suffering from hyperinflation (when commodity prices rise or the currency depreciates exponentially) turn to Bitcoin as a safe haven. Sometimes it’s cheaper to buy two drinks instead of one, because the price for them will rise when you finish the first one. The value of Bitcoin in fiat currency will also rise. Thus, the transfer of wages directly to the military-technical complex provides a liquid (easily accessible) form of wealth storage.
Since the launch of Bitcoin, thousands of other cryptocurrencies have appeared that have improved some technical characteristics and adopted a deflationary token model. Nevertheless, Bitcoin remains the largest and therefore the most reliable and secure blockchain in the industry. There are inflationary aspects of Bitcoin as a reward for miners on the network. However, the project encodes a “halving reward reduction event” – halving, which reduces the inflation rate by 50% every year to ensure its deflationary reliability.
Investors do not need to understand all the subtleties of inflation and deflation in order to save their fortune. It is enough for them to understand the concept of supply and demand. In the case of the BTC, only 21 million coins will be mined, cryptographically immutable and publicly transparent. A proposal with a tight limit cannot be adjusted, manipulated or inflated by centralized or governing bodies. Therefore, with constant supply and constant demand, the value of Bitcoin (BTC) has increased by more than 13,000,000%.
In addition to Bitcoin, there are other deflationary assets with which investors can save their fortune by insuring it against inflation. These include gold, other certain precious metals and real estate. In addition, rare cars and works of art are more portable and affordable assets for investment, having deflationary properties. In addition, with the growth of digital and crypto art in the form of non-interchangeable tokens (NFT), they are also becoming a new form of hedging against inflation. The growth in the cost of NFT is not always guaranteed. However, popular collectibles from well-known artists with high demand usually have a better chance of raising the price.
How does inflation affect cryptocurrencies?
Hopefully, now you understand how cryptocurrencies can protect against inflation. In this section, we will look at how inflation in the traditional financial industry can affect the price of assets in the cryptocurrency industry. As we have just discussed, one of the effects may be an increase in prices for a deflationary crypto asset that hedges against inflation of the local, national currency. However, the percentage by which the rise in prices of deflationary assets counteracts the devaluation of the fiat currency depends on the value of the US dollar.
If, for example, investors transfer their fiat money into cryptocurrency stablecoins (assets with a price pegged to a fiat currency, usually the US dollar), they can still feel the negative effects of traditional inflation. This is due to the fact that the reserve value of stablecoins will lose its value over time. Therefore, stable coins will have less purchasing power to pay for goods.
Another factor affecting cryptocurrencies and inflation, as well as the ability of cryptocurrencies to protect against inflation, is the uncertainty of the market. Uncertainty in traditional markets related to the level of inflation, politics or global events is reflected in the value of stocks. Moreover, cryptocurrency markets still correlate with price action in the traditional market.
Thus, bearish macro trends and events like “black swan” in the traditional sphere can often be observed in the cryptocurrency market. Furthermore, since the cryptocurrency industry is still relatively small, it is also incredibly volatile. This means that sometimes investors may find themselves at a loss, and the cost of the project may drop to zero overnight if the community suddenly loses faith and sells all its assets. Using cryptocurrencies to protect against inflation can be incredibly fruitful and profitable, but it comes with risk. Be sure to do your own research before investing in any cryptocurrency platform or asset.
The discussion of cryptocurrencies and inflation can be confusing. However, we hope that you have understood more about the various definitions of this word in the industry. In addition, when considering the question “do cryptocurrencies protect against inflation?” we advise readers to exercise due diligence when considering the token distribution model of a particular project.
In the traditional sphere of finance, inflation means an increase in the prices of goods or services. Alternatively, we can consider traditional inflation as a percentage of the annual depreciation of the currency.
Conversely, inflation refers to the token issue rate and distribution model in the cryptocurrency industry. Moreover, some cryptocurrency projects, such as Bitcoin, use tokenomics to act as deflationary assets for investors to hedge against inflation. However, not all cryptocurrencies use the deflationary properties of tokens.