Inflationary vs. Deflationary Cryptocurrencies

Crypto investors nowadays face a diverse array of tokenomics. Those can significantly impact market dynamics, so we should be familiar with them and their main features. Two prominent categories within this spectrum are inflationary and deflationary tokens, each governed by unique economic principles. 

Today, we will discuss different types of tokens and look into their details: what makes them unique, what are the examples, and how they affect things like trading volumes, supply regulation, staking, mining, token burns, and market liquidity.

Inflationary tokens explained

Inflationary tokens have a supply that keeps growing over time. This is different from traditional economics, where inflation usually means a decrease in the buying power of money. In the Crypto World, inflationary tokens are used to encourage certain actions within the system.

Examples of inflationary tokens include popular projects like Stellar (XLM), the token of which has a fixed annual inflation rate of 1%. Another example is DOGE which got rid of the supply limitations completely.

What is a deflationary cryptocurrency?

On the flip side, deflationary assets see a decrease in their supply as time goes on. This unique approach is meant to counter the typical inflation we see in traditional economies, and it is more in line with the idea of scarcity. Deflationary cryptocurrencies achieve this by using methods like token burns or setting a fixed maximum supply.

Some well-known examples of deflationary assets include Binance Coin (BNB) and Bitcoin (BTC). BNB uses a real-time burning system, where a portion of tokens is regularly taken out of circulation, making them more scarce. As of February 2024, more than 50 million BNB have been burned.

Bitcoin is also considered deflationary. Its total supply is capped at 21 million coins, mimicking the approach of gold to create scarcity and prevent inflation. In Bitcoin's case, the limited supply is built into its protocol, and new bitcoins are mined at a decreasing rate until the maximum supply is reached, making it inherently deflationary.

The impact on trading volumes

The inflationary or deflationary nature of a crypto project can have a significant influence on its trading volumes. The supply dynamics and economic incentives associated with each model play a crucial role in influencing the trading behaviors of participants. 

Projects with an inflationary model often distribute new tokens as rewards for staking, mining, or participating in other network activities. The fact that crypto is issued continuously can incentivize users to engage more actively to get these rewards, thereby increasing trading volumes.

For them, since new tokens are regularly introduced into circulation, there might be less incentive for long-term holding. Traders may be more inclined to sell their holdings to capitalize on the ongoing token rewards.

As for the deflationary cryptocurrencies, with mechanisms such as token burns or fixed maximum supplies, they often encourage a scarcity-driven mentality among investors. This can lead to a greater inclination to hold onto assets for the long term, reducing the frequency of trades and potentially lowering trading volumes.

The scarcity associated with a deflationary currency may result in fewer tokens being available for trading, as more participants choose to hold rather than sell. This limitation can contribute to lower trading volumes compared to projects with continuous token issuance.

Cryptocurrencies might also adjust their supply over time and use other instruments in their tokenomics to be more flexible with their approach and exhibit a combination of characteristics from both inflationary and deflationary models. The impact on trading volumes will depend on how these mechanisms are implemented and perceived by the market.

Economic models and market liquidity

The way economic models and the type of tokens used can have a noticeable impact on market liquidity. It refers to how easy it is to buy or sell assets without causing a big change in their price. The design of a cryptocurrency, specifically whether it follows an inflationary or deflationary model, affects market liquidity in different ways.

Inflationary tokens, as mentioned earlier, encourage users to actively take part in the network. This active participation can lead to higher liquidity. Additionally, the continuous creation of new tokens in inflationary models ensures a steady supply of assets available for trading. This ongoing token supply can contribute to a more liquid market, as there is a constant flow of tokens for participants to trade.

However, the continuous introduction of new tokens may also result in a dilution effect. This means the market could be flooded with extra tokens, potentially impacting the value of individual tokens. This dilution effect can influence the overall dynamics of liquidity in the market.

On the other hand, deflationary cryptocurrencies, with mechanisms like token burns or fixed maximum supplies, may encourage a HODL mentality among investors. This can result in reduced trading activity, as participants hold onto their assets for the long term, contributing to lower liquidity.

The scarcity associated with deflationary models can lead to a higher perceived value of individual tokens. While this can attract investors, it may also discourage frequent trading, as participants anticipate potential future value appreciation.

Deflationary models can reduce the total supply of tokens over time through mechanisms like token burns. While this scarcity can be appealing, it also means that there are fewer tokens available for trading, potentially impacting market liquidity.

Cryptocurrencies between inflation and deflation

Hybrid cryptocurrencies form a distinctive category in the crypto space. These digital assets seek to find a middle ground between the inflationary and deflationary models.

Hybrid cryptocurrencies adopt an approach that dynamically adjusts their token supply based on specific criteria. The mechanisms governing these adjustments often involve smart contracts or algorithms responding to market demand, token velocity, or other metrics.

These tokens employ algorithms that automatically adjust the token supply. For instance, an increase in demand might trigger the creation of new tokens, mimicking an inflationary effect. Conversely, a decrease in demand might lead to token burns, reducing the overall supply and emulating a deflationary scenario.

Such cryptocurrencies aim to provide a stability of transactions while retaining the potential for value appreciation. By adapting to market conditions, these tokens may offer increased flexibility and responsiveness compared to rigid inflationary or deflationary models.

One notable example that aligns with the characteristics of a hybrid model is Ampleforth (AMPL). Ampleforth employs an algorithmic approach to adjust its token supply dynamically. The supply changes daily based on the price deviation from a target value. If the price is higher than the target, new tokens are minted, creating an inflationary effect. Conversely, if the price is lower, tokens are burned, reducing the overall supply and mimicking a deflationary scenario.

However, challenges exist in implementing effective algorithms and governance mechanisms to ensure stability and fairness. Unintended consequences and potential manipulation are risks that demand careful design and ongoing adjustments. Also, adjusting supply is often not enough to keep the asset’s price stable, because in the inherently volatile crypto market, numerous factors affect this parameter in a way that is extremely hard to predict.

Is Ethereum deflationary?

When Ethereum was first created, it had an inflationary supply. ETH supply was rising 4.5% a year. However, after Ethereum's transition from a proof-of-work (PoW) to a proof-of-stake (PoS) consensus mechanism in September 2022, its supply dynamics shifted. 

Ethereum as a deflationary cryptocurrency is currently seen in mechanisms like burn rates introduced in its economic model. This, coupled with the Ethereum Merge, where PoS replaced PoW, has significantly altered the economic nature of Ethereum, making it a more deflationary currency than Bitcoin according to some experts.

However, in the case of a substantial decline in on-chain activity within the Ethereum network, ETH could revert to being inflationary. This would occur due to a slowdown in the burn rate. For instance, during September-October 2023, Ethereum experienced inflation, with approximately 53,700 tokens added to the supply during that period.

Decentralized governance, facilitated by decentralized autonomous organizations (DAOs), plays a crucial role in shaping the inflation and deflation dynamics of Ethereum. The Ethereum Merge showcases how tokenomics changes are proposed, approved, and executed by DAOs, ensuring that the economic system remains decentralized and governed by the community.

Conclusion

Just like with many other aspects connected to cryptocurrencies, tokenomics and the inflationary vs deflationary models in particular, continue to evolve. Some projects choose to fall in between these two vast categories, trying to strike the most beneficial balance. 

What is more, we saw in the example of Ethereum that even such a cornerstone of the cryptocurrency as its economic model, can shift, being yet another proof of high flexibility of crypto in general. Safe to say, as the sphere matures, these economic principles and their implications will play a crucial role in shaping the future of digital assets.

SimpleSwap reminds you that this article is provided for informational purposes only and does not provide investment advice. All purchases and cryptocurrency investments are your own responsibility.