Objective:
Discuss how these forces impact fiat and crypto.

Outcome:
Learn why Bitcoin is positioned as a hedge against inflation.

Introduction

In the last lesson, we explored how Purchasing Power Parity (PPP) reveals global price variations and their implications for cryptocurrencies. Building on that, this lesson examines two opposing economic forces—inflation and deflation—and how they shape financial systems. We’ll explore their impact on fiat currencies and cryptocurrencies like Bitcoin, as well as why Bitcoin is increasingly seen as a hedge against these forces.

The Forces of Inflation and Deflation

1. What Is Inflation?

Inflation refers to the gradual increase in prices of goods and services over time, often caused by an increase in the money supply. While moderate inflation is considered healthy for economic growth, excessive inflation erodes purchasing power and creates instability. A striking example is Venezuela, where hyperinflation rendered its currency almost worthless, forcing citizens to carry wheelbarrows of cash for basic goods.

Bitcoin, with its capped supply of 21 million coins, offers an alternative. Unlike fiat currencies, which central banks can print endlessly, Bitcoin’s scarcity ensures it is immune to inflationary pressures. This makes it particularly appealing in countries experiencing economic instability.

2. What Is Deflation?

Deflation is the opposite of inflation—a decrease in the general price level of goods and services. It often occurs during economic downturns when consumer spending slows, leading to reduced demand. While this might sound beneficial, prolonged deflation can stagnate economies by discouraging investment and consumption. Japan’s "Lost Decade" in the 1990s is a notable example of how deflation can cripple an economy.

Bitcoin exhibits deflationary characteristics through its halving events, which reduce the rate at which new coins are created. This programmed scarcity not only drives demand but also positions Bitcoin as a store of value during deflationary periods.

Bitcoin’s Role as a Hedge Against Inflation and Deflation

Bitcoin as Digital Gold

Bitcoin’s fixed supply and decentralised nature make it akin to digital gold. Historically, gold has been a hedge against inflation, and Bitcoin now serves a similar purpose. For instance, during the COVID-19 pandemic, central banks worldwide printed trillions of dollars to stimulate economies. While this devalued fiat currencies, Bitcoin’s value surged as investors sought a safe haven.

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Photo by Manny Fortin / Unsplash

Bitcoin’s Deflationary Design

Bitcoin’s deflationary design, such as its halving mechanism, ensures that its scarcity increases over time. Each halving event cuts the reward for miners in half, reducing the new supply of Bitcoin entering circulation. This scarcity, combined with growing demand, drives long-term value appreciation.

Real-World Examples of Bitcoin as a Hedge

  1. Venezuela’s Hyperinflation: As the bolivar lost its value, many Venezuelans turned to Bitcoin as a stable alternative, using it to preserve their wealth and access global markets.
  2. The US Dollar’s Declining Value: During periods of quantitative easing, Bitcoin has consistently been viewed as a hedge against the weakening dollar.
  3. Deflationary Economies: In deflationary environments, Bitcoin’s value proposition as a scarce asset becomes even more compelling. Investors view it as a store of value immune to centralised monetary policies.

Conclusion

In this lesson, we examined the forces of inflation and deflation and their effects on traditional financial systems. Bitcoin’s capped supply and deflationary mechanics position it as a unique hedge against both. In the next lesson, we’ll explore how cryptocurrencies challenge traditional monetary policies, offering a decentralised alternative.