Cryptocurrencies and inflation

Precious metals used to be the best way to protect your portfolio from natural value deterioration, but cryptocurrencies are changing the game.

Inflation means “a decrease in the purchasing power of a currency or asset” or the fact that “most currencies or assets usually lose their value over time”. Prevailing traditional (fiat) currencies constantly lose their purchasing power because central banks print them endlessly, without any restrictions, among other reasons. This means that less money is bought for the same amount of money than before and even less will be bought in the future than now. All financial systems take the inflation phenomenon into account. Cryptocurrencies, which are largely financial assets, also have the same concept of inflation.

What is inflation?

Inflation is defined as the growth of the money supply minus the growth of the total value of goods and services in an economy. This can be imagined as follows:

Imagine that you have a limited budget. Suppose you are a student and your daily food budget is $10. It is 16:00 and you are on your way home after studying. You are hungry and have already spent $9. There is only $1 left, which you are ready to spend today. It’s a good thing there is a cheap pizza place on the way home, and you can buy a slice of pizza there for just $1! But what if you found yourself in the same situation the next week, after a period of inflation, would change this desire or ability to buy the same slice?

After a period of inflation, this 1 dollar is no longer as valuable on the way home because the pizza price has risen to $1.50. You can buy for the same dollar less than before.

The downside: an inflationary spiral

As your purchasing power drops in line with your current income, you will seek to increase this income and ask for an increase. After consumer prices rise, you usually see your wages increase. However, this can lead to a loop, as rising wages can increase consumer spending as well as production costs, which in turn will lead to higher prices again. This is known as an inflationary spiral.

Although it may seem that it is easy to avoid an inflationary spiral, inflation targeting is actually an inaccurate and indirect process subject to uncertainty.

In traditional economies, central banks are responsible for increasing or decreasing money supply — this can be seen as “printing” or “burning” money, although this is actually the responsibility of the Treasury. The aim of central banks is to ensure financial stability. In most cases, this is achieved through their power to stabilise inflation with clear target rates or ranges. There are two main ways in which central banks set inflation targeting:

  • buying or selling assets;
  • adjusting the interest rates they charge commercial banks.

All together this is called monetary policy.

Unfortunately, these instruments have limited impact on prices and interest rates in the economy. The ability of central bank policy to influence inflation is known as a transfer mechanism which is characterised by long, variable and uncertain time lags. It is therefore difficult to predict the exact impact of monetary policy actions on the economy and price levels.

What are the positive effects of money supply growth?

It is important to note that money supply growth does not necessarily lead to inflation if the economy is experiencing a corresponding increase in the cost of goods and services. In fact, it could be argued that a productive and prosperous economy requires money supply growth to support it. Although such a system may become more productive over time, it is subject to financial instability due to the debt cycle (business cycle fluctuations) and difficulties in targeting inflation.

Despite this complexity, the vast majority of countries choose to target a certain level of inflation. This has several advantages for central banks and governments as it reduces the cost of debt over time and provides flexibility in monetary policy. Perhaps even more important: a growing money supply encourages investment in productivity growth in the short term.

Imagine that you have a great idea for a new company. If the money supply is stable and you have a well-paying job, you have very little incentive to take risks and start up this company yourself. However, as the money supply grows (before prices and wages rise), you have a greater incentive to invest in your idea with the awareness that it can bring you more than you currently earn.

At the same time, money supply growth leads to a fall in the real interest rate. This leads to a desire on the part of investors for higher returns on ideas with higher risk. Increased investment in promising ideas today leads to higher long-term economic productivity.

How can the increase in token supply support the growth of a token-based economy?

Just as a growing money supply supports the productivity and growth of traditional economies, a productive and growing token-based economy requires a growing token supply to support it. The growing supply of tokens will create incentives for greater consumption and investment in networks and lead to increased productivity and value in this economy in the long term.

In addition, the growing supply of tokens, when used for payment and network security, supports the growth of a token-based economy. This enables the network to achieve maximum value.

Take the example of a network that awards transaction validators. In order to achieve the optimal level of transaction load (to achieve the highest value in the economy), both fees and the growing supply of tokens must be used as a network expense. This means that validators receive fees from users for checking transactions — and they are also rewarded by the growing supply of tokens. If only fees were used to pay for transactions, the system would reach a lower equilibrium value and would incur a non-refundable loss for this security payment. When this security payment is made both through fees and by increasing the token supply, a more favourable equilibrium is achieved.

As the growing number of tokens is distributed among the validators, additional incentives are created to invest these tokens in the network. There is a greater incentive to increase the share, so that the revenue potential can be increased. The result is a greater safety margin and a higher level of transactional load on the network.

What other advantages and vulnerabilities can the growing supply of tokens bring?

There are several ways to effectively implement the growing token supply in a token-based economy. The optimal way for a particular network will depend on the characteristics of that system. Some of the important variables to consider:

  • What kind of work is important for this system?
  • Who is entitled to receive the new stock of tokens? What kind of work do they do, what is important for the network?
  • What percentage of tokens should be used to pay for the job?
  • What is the optimal growth rate of token supply?

Using the models presented in this article can be extremely informative to understand not only the impact of these variables on your economy, but also potential vulnerabilities. For example, determining whether a network should be spent on security. Otherwise, it becomes an unnecessary premium that could have been spent otherwise. In order to be effective, a growing supply must pay for security directly, instead of, for example, turning to everyone in the network as a dividend — regardless of who does the work for network security.

Although models and simulations are an important part of the design process, some things we learn practically. It is not yet known what the optimal balance of rewards and transaction fees is. Or the optimal inflation rate for these different types of economies. Best practice dictates that models and simulations be created to study these implications before the network is launched and real value is at stake. However, in the coming years we are going to learn a lot from practice. There are exciting times ahead!

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Blockchain enthusiast developer and writer. I love video games, blockchain and the hot symbiosis of these two worlds.

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Jeffrey Hancock

Jeffrey Hancock

Blockchain enthusiast developer and writer. I love video games, blockchain and the hot symbiosis of these two worlds.

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