Deflation refers to a general reduction in the prices of goods or services in an economy. In the world of cryptocurrency, it refers to an increase in the value of a digital currency.
The Long Explanation
To those familiar with the field of economics, deflation is not a new concept. In macroeconomics terms, it is a prolonged and widespread decrease in prices of goods and services over time. It is usually driven by a decrease in demand, an increase in economic productivity, or contractionary monetary policies.
In general, deflation is associated with periods of financial crises and economic recession. But it also means higher purchasing power for holders of the currency who are able to buy more goods at a lower cost. It is in this latter part that cryptocurrency finds its definition of deflation.
In cryptocurrency, deflation refers simply to an increase in the value of a digital currency over time. Unlike fiat currency, the deflation of a digital currency is always a good thing as it grants more value to holders of the currency.
By default, most digital currencies are deflationary in nature as they boast finite supplies from source. Deflationary digital currencies may also go a step further to ensure continuous increase in value by writing deflationary rules into their smart contracts.
A great example of deflation in cryptocurrency can be found in the King of Crypto, Bitcoin. Its deflationary nature is defined by two primary rules.
First, its supply is capped at a maximum of 21 million tokens. Second, the concept of “halving” written into its development ensures that 50% of the bitcoin rewards to be received by miners for the validation of blocks will be destroyed every 4 years.
The above has seen the value of Bitcoin continually increase – rather than decrease – over time. This deflation is further driven by hoarding, increased adoption levels, and even the loss of BTC tokens over time as token holders lose access to their private keys.
For most other digital currencies, deflation is ensured by means of token “burning”. This is a deliberate action initiated by the team behind the currency that sees notable amounts of the token destroyed (withdrawn from the market supply). This process if often fully automated via smart contracts.
To be clear, the deflationary mechanisms instituted by a crypto project may not lead to the expected increase in value. However, it’s no surprise to see more and more cryptocurrency projects turn to deflationary mechanisms to ensure the continued increase in value of their tokens.
