One of the key features of Bitcoin is the limited supply of 21,000,000. In other words, it is deflationary by nature. Other tokens, like Ethereum, have a constant flow of new assets added to the ecosystem, which makes them inflationary.
It is common to think of inflation as something negative because it makes money cheaper. From the consumer perspective that is true, but it is more complex on a bigger scale. In this article, we will explain how fixed and unlimited supply works in fiat and cryptocurrencies.
Unlimited Supply — Inflation
You don’t have to be an economics professor to understand the concept behind inflation. It is pretty straightforward — the money loses in value when more money enters the economy.
In 1940 in the US you could buy a gallon of gas for just $0.11. Now it is around $2.50/gallon. It hasn’t gotten more expensive to produce gasoline. It just that the $USD is less valuable than it was 80 years ago.
In fiat economies, the monopoly for issuing new cash belongs to the central banks. That makes all major fiat currencies inflationary. The consumer negativity towards inflation is understandable. Nobody likes to buy goods at a higher price.
But here is also a positive side — inflation forces consumers to spend more money here and now. Active money circulation in the economy stimulates the growth of businesses and reduces unemployment.
In cryptocurrency ecosystems, the protocols with infinite supply play the roles of central banks and have their own rules for issuing the new coins. The most known cryptocurrency with an unlimited supply is Ethereum. However, it is only infinite given an infinite amount of time, as the developers issue a fixed amount of Ether per year.
Ethereum has inflation. But in practice, the more ETH is mined the lower goes the inflation. Why? Instead of decreasing the amount of new Ethereum developers decided to issue a fixed amount per year. So the same 18 million ETH is mined every year irrespective of the total supply.
Therefore technically, the percentage of inflation is decreasing every year. When the supply of Ethereum is at 100 million and 18 million Ether is mined, the inflation is at 18%. A few years down the line when supply is at 200 million, the same 18 million ether will be mined. Then inflation is only at 9%.
This also does not have a major effect on the price of Ehereum because the ETH is different from the $USD or $EUR in its utilization. Fiat money is essentially only a note of debt. When you pay $5 for a sandwich at a cafe you basically say “I owe you $5” to the clerk.
Ethereum is different, as the price of ETH indicates the overall health of the ecosystem and the investor’s trust towards it. ETH also finds utilization in the form of Ethereum Gas used for transaction fees on the Ethereum blockchain.
Limited Supply — Deflation
Deflation is the opposite of inflation. In short, it means that the money/asset in circulation gains value over time. Some would say “Great, I can keep my dollars under the mattress so I can buy more stuff in the future!”.
But Keynesian economists will not agree with you. They claim that people holding their assets for a long negatively affects the economy. If consumers focus too much on saving, then there will be less money in active circulation. This weakens the economy and increases the unemployment rates, as the financial system is not able to support the businesses.
In the worst-case scenario, it may lead to a “deflation death spiral.”. This concept signifies that the prices for goods decrease while consumers continue to hold their money, waiting for even lower prices.
The assumptions we make in economics are based predominantly on an inflationary practice, but there are still some real-life examples of deflation. One of them is Japan, where deflation was a real problem back in the 90s. They even got a frightening name for it — “deflation monster”.
It arose from the significant oversupply of goods over the real demand of Japan’s population. The response of the central bank was adopting negative interest rates. You are right, they actually paid people to take loans to fix the problem.
Deflation and Cryptocurrencies
In cryptocurrencies, the vast majority of coins are set to have a limited supply. The obvious example is Bitcoin with a limited supply of 21 Million coins. At the moment of writing 88% of Bitcoin (18.5 Million coins) has already been mined. On top of that, more than 1.5 Million Bitcoins were gone forever due to the wrong address transactions and lost private keys. Just to be clear — that is more than 17 Billion $USD.
But what happens when there are no Bitcoins left to mine? First, this will not happen soon. The estimated date for the last Bitcoin is 2140 due to halving. Secondly, nothing serious will really happen. This issue will mostly affect the miners, but Satoshi Nakamoto thought about them too. He predicted that the source of dividends for miners will change from producing new Bitcoins to receiving rewards in fees for transactions.
It will not affect the regular users that much as Bitcoin has the answer — high divisibility. You can divide Bitcoin into eight decimal places (Satoshis). Nakamoto claimed that it would ensure the possibility to make small purchases. This prevents the situation, similar to paying with a $10 bill for a $2.5 coffee and not receiving any change.
Limited and infinite supply works differently in crypto and fiat ecosystems. Fiat economies are all equal to each other in the sense that inflation affects them all. It is healthy for the economy itself but forces regular consumers to overspend. Deflation is good from the consumer point of view but weakens businesses and forces unemployment.
In crypto ecosystems, everything is simpler. A fixed supply constantly forces the price of the asset to increase. Unlimited supply, on the other hand, may actually lead to a high inflation rate, but developers design the ecosystems in the way that it is actually never really unlimited.