In the United States, inflation is at a 40-year high. Prices are rising faster than wages, causing some people to pour their money into alternative assets touted as inflation hedges, like bitcoin (BTC) – the native cryptocurrency of the Bitcoin network.
Their creators hoped that decreasing the token supply over time would increase their value. Here’s what you need to know.
Inflation and crypto – a primer
If a currency is subject to inflation, it means that its purchasing power will fall over time. In other words, each unit of that currency – one U.S. dollar, euro or bitcoin – cannot be used to buy as much as it used to.
Central bankers don’t think that inflation is always bad – at low, stable levels it encourages people to spend, thereby stimulating economic growth. But too much of a good thing is not healthy; inflation can hurt if you aren’t receiving a proportionately larger salary, and volatile inflation makes it difficult to budget effectively.
The U.S. Federal Reserve tries to keep the inflation of fiat currencies at around 2%. By contrast, cryptocurrencies are decentralized, meaning there isn’t a central bank. Crypto developers play that role, and some decentralized autonomous organizations (DAO) also vote on a project’s tokenomics, although voting is decentralized across token holders.
Many cryptocurrencies have fixed issuances. The Bitcoin protocol, for instance, decreases the issuance of new bitcoin at a fixed rate, and once all 21 million bitcoin have been mined – predicted to be sometime next century – nobody can mint any more.
Read more: How Does Bitcoin Mining Work?
Some cryptocurrencies are inherently inflationary, meaning the number of coins in circulation rises over time. New cryptocurrencies can be mined into existence – that’s how Bitcoin works – or issued to proof-of-stake validators.
Issuing new cryptocurrencies to network actors encourages participation. Some inflationary currencies have fixed supplies, while others have unlimited supplies – there is no limit to the number of tokens that could be in circulation.
Dogecoin, for instance, has an unlimited supply after one of its creators, Jackson Palmer, abolished a hard cap of 100 billion DOGE in February 2014. That means increases in supply could outpace increases in demand, potentially decreasing the value of each individual dogecoin over time.
Coins like bitcoin are inflationary to a point. There is a hard cap in place, but the protocol has disinflationary measures – those that slow the rate of inflation over time. The main one is the “halving” that cuts the amount of bitcoin miners receive approximately every four years
The supply of some cryptocurrencies deflates over time, meaning that so long as demand remains consistent (a big hypothetical) the price of each individual coin will rise.
Mixing and matching
Like central banks, some cryptocurrencies employ deflationary, inflationary and disinflationary mechanics to keep the price in check.
The TerraUSD (UST) stablecoin, for instance, both burns and mints tokens to maintain a price of $1. The Terra network relies on a dynamic supply and a free market of arbitrageurs to keep the price of its stablecoin afloat.
Ethereum, whose ether was once a purely inflationary coin, in August 2021 implemented a mechanic called EIP-1559 that burns tokens instead of handing them to miners. At times of high network activity, burn rates have temporarily made the coin deflationary, meaning that more tokens are destroyed than created.
XRP, too, has deflationary mechanics – the token is burned to pay for transactions. But in 2017, Ripple, the company that manages XRP, placed tens of billions of XRP in escrow to prevent a market dump. It periodically releases them into the market, thereby increasing the circulating supply. Messari notes, “At the current burn rate, it would take 20 years for the XRP Ledger to burn what is distributed by Ripple and its founders every day.”
These days, decentralized autonomous organizations can influence the rate of inflation. DAOs vote to release funds locked up in community treasuries, for instance, by determining staking rewards and setting vesting periods for early investors.