Cryptocurrency and Inflation Mechanisms

Inflation is one of the major problems in the economy because it can bring negative effects on many aspects of social life. Venezuela is a prominent example with a high inflation rate of nearly 8,000,000% that has had serious consequences in this country. Specifically, most entrepreneurs in this country cannot start new businesses or grow their projects due to a lack of capital. People living in poverty are in danger of the shortage of food and consumer goods. However, it's supposed that inflation in these countries can be solved by the circulation of crypto because this currency is viewed as a good hedge against inflation. This article will provide concise information about the issue of inflation in the crypto market as well as the mechanisms to combat it.

What is inflation?

Inflation is a measure of the rate of rising prices of goods and services in an economy. If inflation is occurring, leading to higher prices for basic necessities such as food.

The consumer price index (CPI) will be used to measure inflation. This is an index that is carried out by the state agency in order to measure the increase or decrease of a certain commodity. 

Inflation in the crypto market

The most basic difference between fiat money and cryptocurrency is supply. While more and more fiat money is being printed by central banks over time that can lead to a reduction in the value of the currency. Although Crypto is still mined and created every day, its supply is finite. For example with Bitcoin, the total number of bitcoins will never exceed 21 million. In addition, cryptocurrencies are decentralized, which means that no central bank or third party can change the value of the currency. Although the crypto market still has inflation and this rate is different for each token, inflation in this market is better controlled. That’s why more and more investors are entering the crypto market to store assets and make long-term investments.

Inflation mechanisms

Although crypto has its own advantages to curb inflation, due to the massive development of new projects, including many garbage coins, investors tend to suffer losses. To solve the above problem, projects have been using measures to control inflation and the most common of which is coin burning.

Coin burning is a process where cryptocurrency miners and developers remove a specific portion of coins from circulation to control their price, resulting in slowing down in the inflation rate. It is a common industry practice to incentivize long-term holding among users, by managing the price through restricting supply.

In order to burn coins, miners place them in an unrecoverable public wallet called an “eater address”. At that time, no one has access to this key nor use these tokens for transaction purposes. Developers, as well as investors, expect that burning coins will create scarcity of coins in order to increase their value.

As a specific example of coin burning, 55 billion XML was burned and it significantly reduced the supply of XLM by more than 50%. The price impact on XLM is immediately noticeable in the short term, growing 25% from $0.069 to $0.088 in a single day from Nov 5 to Nov 6, 2020.

Conclusion

Although coin burning is a widely trusted measure to reduce inflation, this method does not always increase the value of that coin, on the contrary, it can also reduce the supply in an unnecessary way. Therefore, investors need to consider the token burn schedule to make investment decisions.