We shall be looking at what inflation in cryptocurrency is, its causes and possible mitigation. Is inflation a bad thing? Can it ruin an ecosystem?
Well, you can best tell what it truly represents and how it can be mitigated or controlled.
Our discussion today is about inflation and we shall be looking at it from fiat currency point of view and the cryptocurrency.
What is inflation in cryptocurrency?
We often hear the word ‘inflation’ and we wonder what it is and how it comes about.
In this series we shall be learning; what inflation is, its effects in the decentralized ecosystem as it does the real world and learn about its mitigants.
By definition, “inflation refers to the general increase in prices of goods and services in an economy over time, thereby eroding the value of money and reducing what each unit of currency can buy.”
Does this also refer to the cryptocurrency world? YES! Yes it does and that is why we are reading through this article.
As you must have learnt, inflation is everywhere and yes, it affects the decentralized ecosystem as it does the real world.
In the cryptocurrency world, just as in the real world, there is inflation and it affects every asset just as it affects fiat currencies.
Inflation in cryptocurrency refers to the increase in the supply of a particular cryptocurrency over time thereby, resulting in a decrease in its purchasing power or value relative to goods and services.
Causes of inflation in Cryptocurrency.
We will be looking at the causes and factors that contribute to inflation in cryptocurrency and get to understand the ecosystem.
1. Block Rewards: Block rewards contribute to inflation in cryptocurrency. This is when miners are rewarded with newly minted cryptocurrency for their efforts.
Many cryptocurrencies, including Bitcoin and Ethereum, use a proof-of-work (PoW) consensus mechanism, where miners compete to validate transactions and add new blocks to the blockchain.
2. Token Issuance: The issuance of new tokens through initial coin offerings (ICOs), token sales, or airdrops can increase the supply of the cryptocurrency, leading to inflation if not accompanied by sufficient demand or utility. Inflation in cryptocurrencies occurs when too many new coins are issued.
Bitcoin and many other blockchain projects issue their own tokens or coins to fund development, incentivize participation, and for the facilitation of transactions within their ecosystems. This all causes inflation if the amount is too much or too little.
3. Forking Events: Forking in cryptocurrency is where a blockchain splits into two separate chains due to differences in consensus rules or community disagreement, or a hack like in the case of Ethereum and Ethereum Classic.
A forked blockchain increases the overall supply of the cryptocurrency ecosystem, which in turn contributes to inflation if the newly created coins are not sufficiently valuable or scarce.
4. Governance and Protocol Changes: How does this cause inflation in cryptocurrency? Well, if a decision is made to increase the block reward or adjust the supply schedule through a network upgrade or consensus change of a Blockchain can affect the rate of new coin issuance and inflation.
A change to the governance or protocol of a cryptocurrency network can impact its inflation rate as it does in the real world.
5. Halving Events: Halving is when the block rewards for miners are halved and by halved, we mean, reduced and this is said to reduce the issuance of new coins which in turn slows down or heightens inflation.
Some cryptocurrencies have built-in mechanisms to control inflation over time. It is inbuilt in the code and it triggers at a given time. A perfect example of this is Bitcoin which undergoes halving events approximately every four years.
6. Lost Coins: Yes, lost coins can cause inflation and with the irreversible nature of cryptocurrency, incidents like lost private keys or forgotten passwords lead to loss of coins.
This lost supply effectively reduces the total circulating supply and may contribute to inflation by making the remaining coins more valuable.
Mitigants to Cryptocurrency inflation.
Yes, inflation in cryptocurrency can be mitigated and below are some steps that can help.
1. Proof-of-Stake (PoS): PoS consensus mechanisms can mitigate inflation in cryptocurrency because it doesn’t rely on miners to validate transactions. PoS is a system whereby validators are chosen based on the number of tokens they hold and are willing to “stake” as collateral.
This system of network provision has lower inflation rates compared to PoW networks.
2. Community Governance: Remember that, the crypto economy has a unique model of governance right? Well, this model mitigates inflation in cryptocurrency because it allows the community to make decisions regarding token issuance and supply adjustments.
When there is a transparent governance process, inflationary pressures are kept in check and aligned with the community’s interests.
3. Fixed Supply: Bitcoin is a very good example of this method of mitigating inflation. As we all know, Bitcoin has a capped supply of 21 million coins and that means, once the last of the 21 million coins is mined, that figure can not be exceeded. If at anytimes there is any coin over that amount, they will be reduced in a process called halving.
With a fixed supply, the inflation rate of the coin decreases over time and there is structure.
4. Economic Policies: To mitigate inflation, cryptocurrencies can implement economic policies, like decentralized autonomous organization (DAO) governance, an algorithmic monetary policy to assist the process or, token issuance can be adjusted based on market conditions in a bid to maintain price stability.
5. Burn Mechanisms: This process involves where decisions are made to permanently remove (burned) some tokens from circulation thereby reducing the total supply and countering inflation.
This can be achieved through transaction fees, token burns, or other means.
In conclusion,
Inflation has the same effect it has on the crypto economy as it does in the fiat economy and we must understand why it happens and how to manage it.
In the case of cryptocurrency and way different from the fiat economic model, decentralized and programmable nature of cryptocurrencies allows for innovative mitigants to manage inflationary pressures.
However, when working out a model to tackle inflation in cryptocurrency, it is essential to note that each cryptocurrency’s inflation dynamics are unique, therefore mitigants should be tailored accordingly to address specific challenges.
