Course:
Money
In a world where prices rise faster than wages, the pressure of inflation is something everyone feels, whether you’re buying groceries or managing investments. But what if inflation, that same source of stress, is also necessary for economic growth? In a video detailing the mechanics of inflation and government responses, we are taken on a journey through a complex web of rising prices, wage growth, and central bank policies. These principles don’t just shape traditional markets, though—they also reverberate through the world of cryptocurrencies, where the balance between inflationary and deflationary forces has profound effects on token values and decentralized finance (DeFi). In this article, we’ll explore how inflation impacts both the financial and crypto ecosystems, and why understanding it could be key to navigating our evolving economic future.
The video in question outlines a thorough examination of inflation, focusing on why prices tend to rise and why governments actually aim for a small degree of inflation, rather than zero. One of the most striking points is the idea that inflation, when controlled, is a “virtuous cycle” that encourages spending and boosts economic growth. Consumers, expecting prices to rise, make purchases sooner, creating demand. This increase in demand leads to higher production, more jobs, and ultimately, wage growth that offsets the rising prices—at least in theory.
However, the video also highlights the challenges of inflation when it spirals out of control, as seen during 2022 when inflation rates in the U.S., U.K., and Eurozone peaked at 10%. The analysis of government responses, particularly interest rate hikes, shows how complex the management of inflation can be. What’s more, the concept of deflation is introduced as an even more dangerous cycle, where falling prices lead to reduced spending, job losses, and economic stagnation. By the end of the video, we’re left to grapple with the fact that inflation is both a blessing and a curse, depending on how it’s managed.
The video successfully outlines the necessity of inflation targets and the concept of the “virtuous cycle.” One of the strongest arguments is that moderate inflation encourages immediate consumer spending, which is essential for economic growth. This mirrors traditional financial principles, where incentives are created for people to purchase goods now rather than later. In the crypto world, similar dynamics occur, especially in the context of tokenomics. For example, projects like Ethereum, which moved to proof of stake, build in inflationary mechanisms to encourage staking and participation in the network.
Another compelling point is the discussion around wage growth in relation to inflation. In traditional markets, when wages keep pace with rising prices, the economic impact on consumers is softened. This mirrors the crypto space, where inflationary coins need to balance token supply with increasing demand to maintain value. Projects that fail to do so see their token prices collapse under the weight of oversupply—a clear parallel to wage stagnation leading to economic hardship.
The video also emphasizes the government’s role in managing inflation through interest rate hikes. By making borrowing more expensive, governments can curb demand, thereby reducing inflation. This concept also exists in the decentralized finance (DeFi) world, where protocols can adjust interest rates on loans or increase staking rewards to control inflationary pressures within their ecosystems.
While the video offers a solid breakdown of inflation and its management, it doesn’t fully address the long-term impacts of interest rate hikes on financial markets or crypto. For instance, while interest rate hikes help control inflation, they can also stifle innovation and long-term investments by making capital more expensive. In crypto, higher rates could lead to reduced liquidity in decentralized exchanges or lower staking participation, which could affect the health of a protocol.
Additionally, the video could have delved deeper into the complexities of wage growth. While it mentions wage growth surpassing inflation in mid-2023, it doesn’t explore how this wage growth might be uneven across sectors or regions. For example, in many developing countries, wage growth still lags significantly behind inflation, leading to continued financial strain. In crypto, this mirrors the uneven distribution of token rewards, where early adopters or “whales” often benefit disproportionately, leaving smaller investors at a disadvantage.
Lastly, the video simplifies the causes of deflation, suggesting it is rare and primarily solved by economic shocks. While true, it glosses over how prolonged periods of deflation, like in Japan, show that economies can become trapped in deflationary spirals without easy fixes. In decentralized finance, deflationary mechanisms are sometimes built in, such as token burns, which can lead to unintended consequences like liquidity crises or overly scarce tokens that stifle ecosystem growth.
Inflation and deflation aren’t just concepts that apply to fiat currencies—they also play a critical role in the crypto ecosystem. In the world of blockchain, inflationary tokens are designed to reward participants and incentivize network security. For example, Ethereum’s shift to proof of stake includes an inflationary model that rewards stakers while simultaneously reducing the overall issuance rate. However, the delicate balance between token supply and demand must be maintained. If inflation is too high, token values can plummet, as seen with some projects that have struggled to manage tokenomics effectively.
On the other side, deflationary mechanisms, like token burns, are becoming increasingly popular in crypto. By removing a portion of tokens from circulation, projects like Binance Coin (BNB) aim to increase scarcity and drive up value. While this sounds appealing, it can also create challenges. For instance, if too many tokens are removed from circulation too quickly, liquidity can dry up, causing price volatility.
In the realm of DeFi, inflationary and deflationary dynamics are constantly at play. Protocols like MakerDAO adjust their stability fees (interest rates) to control the supply of DAI, their stablecoin. When DAI demand is too high, fees are increased to curb issuance, preventing inflation of the token. This mirrors how central banks use interest rates to manage national currencies, showcasing how decentralized systems are adopting similar mechanisms to traditional financial systems.
Looking at the bigger picture, inflation and deflation are not just financial buzzwords—they shape the very foundation of economies and markets. As we look toward the future, the role of inflation management will become even more crucial, especially in a world where technology and finance are increasingly intertwined. Cryptocurrencies offer an intriguing testbed for new economic models, where inflationary and deflationary pressures can be programmed directly into the system, creating a new level of transparency and control that traditional markets often lack.
The rise of DeFi could play a transformative role in how we manage inflation at both macro and micro levels. With decentralized protocols, individuals have more control over their assets, and inflationary policies can be debated and adjusted by the community. However, this decentralization also comes with risks—if governance systems fail to act swiftly or equitably, inflation could run rampant in these systems, just as it can in national economies.
The future may see a convergence of traditional finance and blockchain, where inflationary mechanisms are better understood and applied through smart contracts and automated systems, potentially reducing the need for centralized intervention by banks or governments. But as with any emerging technology, there will be growing pains, and the challenge will be finding the right balance between innovation and stability.
Having worked extensively in both traditional finance and the blockchain space, it’s fascinating to see how inflation, something often viewed as a traditional economic issue, is equally relevant in decentralized systems. One thing that stands out to me is how easily the crypto world can replicate the same inflationary dynamics we see in fiat currencies, yet it has the added complexity of being global, decentralized, and driven by code. This creates opportunities for innovation but also risks that we are only beginning to understand.
For example, inflation in a decentralized context gives users more agency, allowing them to participate in governance decisions that directly affect the money supply. However, this also places more responsibility on the user, requiring a deeper understanding of how these mechanisms work. In my view, the key to success in the future will be education—helping people understand not only how inflation works in the traditional sense but also how it applies to their crypto holdings.
In conclusion, inflation may seem like an economic buzzword, but its effects are profound, shaping everything from your grocery bill to the value of your crypto holdings. While governments work to manage inflation through interest rates and fiscal policy, decentralized systems are experimenting with new ways to balance inflationary and deflationary pressures. Understanding these dynamics, whether in fiat or crypto, is key to navigating the future of finance. As technology continues to reshape the world, those who grasp the complexities of inflation will be better positioned to thrive in this rapidly changing landscape. Whether you’re holding dollars or Bitcoin, inflation is a force that you cannot afford to ignore.
In 2022, much of the world faced a period of historically high inflation, with the U.S., U.K., and Eurozone experiencing inflation rates peaking at around 10%. This meant that prices were 10% higher on average compared to the previous year, which was no surprise to anyone dealing with rising costs. While inflation has since come down closer to the normal range, it’s important to remember that prices haven’t dropped—they’ve just stopped rising as fast. For businesses and consumers alike, this still poses significant challenges.
Now, if you’re new to the world of crypto or finance, you might wonder: “Why can’t prices just stay the same?” In order to answer this, we must explore why inflation happens, its benefits, and the potential consequences of both inflation and deflation. Understanding inflation is crucial not just for those focused on traditional markets, but also for anyone involved in crypto, as inflationary and deflationary forces can affect everything from token values to market behavior.
Inflation refers to the rate at which the general level of prices for goods and services increases, eroding purchasing power over time. In simpler terms, your money buys less as prices go up. It’s important to note that inflation isn’t always a bad thing. A little inflation is often seen as beneficial to the economy. Governments and central banks often pursue what’s called an “inflation target,” usually around 2%. This target is meant to create a “virtuous cycle” in which moderate price increases encourage spending, investment, and job creation.
The idea behind moderate inflation is that when prices rise slightly, consumers anticipate that they’ll continue to rise, so they spend money sooner rather than later. This increased spending boosts demand, which encourages companies to produce more, hire more people, and pay higher wages. In theory, as long as wages rise alongside prices, purchasing power remains stable. For instance, when wages keep pace with inflation, people can still afford the same amount of goods and services.
However, when inflation outpaces wage growth—as it did in many countries from 2021 to 2022—it can create financial stress. This imbalance forces consumers to pay more for necessities without a corresponding increase in income, leading to economic strain. Fortunately, in mid-2023, wage growth began to surpass inflation, at least in some sectors. This was a positive development, especially in areas where wages had been stagnant for too long.
Unfortunately, the inflationary cycle doesn’t always work as intended. Disruptions such as supply chain interruptions, or even corporate-driven price hikes, can turn a virtuous cycle into a vicious one. For instance, when companies raise prices not because of genuine cost increases but to boost profits, consumers are hit even harder, worsening the inflation problem. In the crypto world, this is akin to when gas fees or transaction costs surge due to network congestion, affecting everyone transacting on the blockchain.
The result of such disruptions is often runaway inflation, which erodes consumer confidence, reduces purchasing power, and slows economic growth. In response to these disruptions, governments usually turn to monetary policy—primarily through adjusting interest rates.
One of the most effective tools governments have to combat rising inflation is raising interest rates. When interest rates increase, borrowing becomes more expensive, which discourages spending and investment. This, in turn, can slow down economic activity, bringing inflation closer to the target of 2%.
For example, in 2022, the U.S. Federal Reserve raised interest rates in an effort to curb inflation. While this helped in reducing inflation closer to the target, it also placed a higher financial strain on families needing loans to make ends meet. Crypto markets can be particularly sensitive to these shifts in monetary policy, as higher interest rates can reduce the flow of fiat money into cryptocurrencies, leading to lower demand for digital assets.
Deflation, the opposite of inflation, occurs when prices fall. At first glance, falling prices might seem like a good thing, but deflation can lead to a dangerous cycle known as a “deflationary spiral.” When consumers expect prices to continue falling, they may hold off on making large purchases, waiting for even better deals. This delay in spending reduces demand, which forces companies to lower prices further, cut costs, and lay off workers. As unemployment rises, people spend even less, deepening the economic decline.
Deflationary spirals are notoriously difficult to fix, as governments have fewer tools to combat falling prices compared to rising ones. In fact, historical periods of deflation, such as the Great Depression, required significant economic shocks—like the outbreak of World War II and massive government spending—to break the cycle. More recently, Japan has spent decades grappling with chronic deflation, only recently emerging from it thanks in part to the global inflationary pressures seen in recent years.
For those new to crypto, it’s crucial to understand that inflationary and deflationary forces can also apply to digital assets. For example, some cryptocurrencies have built-in mechanisms that mimic inflation by steadily increasing the supply of tokens (e.g., Ethereum’s shift to proof of stake). Others are inherently deflationary, like Bitcoin, which has a hard cap on the total number of coins that can ever be mined.
In the crypto ecosystem, inflation can impact the value of tokens by increasing supply, which may dilute the value of individual holdings if demand doesn’t keep pace. On the other hand, deflationary forces, such as token burns (where tokens are permanently removed from circulation), can increase scarcity, potentially driving up the value of the remaining tokens.
Understanding these dynamics is essential for making informed decisions in both traditional and crypto markets.
Inflation Targeting: Governments and central banks aim for moderate inflation (around 2%) to encourage spending and investment. This is designed to create a balance between price increases and wage growth.
Consumer Behavior: Rising prices can drive people to spend sooner, boosting demand, but this works only if wages keep pace with inflation. In crypto, price speculation can have similar effects, where users rush to buy assets before prices surge.
Government Actions: Raising interest rates is a common tool to fight inflation, but it also affects crypto markets by potentially reducing the flow of fiat money into digital assets.
Deflation Risks: While deflation might seem appealing due to falling prices, it can trigger a harmful economic cycle. Similarly, in crypto, deflationary mechanisms can both help and hurt the ecosystem, depending on market conditions.
Inflation is a complex, multifaceted issue that impacts both traditional and crypto markets. While moderate inflation is seen as a healthy economic driver, runaway inflation or deflation can have devastating effects. Governments use tools like interest rates to manage inflation, but those involved in crypto should also be aware of how inflationary and deflationary pressures affect digital assets. By understanding these forces, you can make better-informed decisions, whether you’re investing in fiat markets or exploring the world of cryptocurrencies.
This lesson offers a comprehensive understanding of inflation, deflation, and their implications in both the traditional financial system and the emerging crypto world. Whether you’re new to finance or a seasoned crypto investor, grasping these concepts is key to navigating the complexities of economic forces.
“In 2022, much of the world experienced a period of uncommonly high inflation, with the U.S., U.K., and Eurozone all peaking at around 10%. This meant that prices, on average, were a full 10% higher than one year before. Though that’s probably not a surprise to anyone watching this, it’s thankfully now closer to the normal range, though still a bit high. But, infuriatingly, since this chart just shows a rate of change, that doesn’t mean prices are down—just that they’ve stopped climbing as fast. And that really sucks. Consumers are stressed, businesses are suffering, and governments are scrambling.
At the same time, if you were to find yourself reading and watching a ton of inflation-related content, you’ll also keep hearing this: “A little inflation is a good thing.” Why? If rising prices hurt seemingly everyone, why can’t they just stay the same? Why can’t inflation be zero?
The first reason inflation can’t stay at zero is because governments and their central banks don’t want it to. Many countries actively pursue what is called an “inflation target.” In the U.S. right now, it’s about 2%. In fact, that’s the number used by most central banks across the world. But the truth is, that’s a pretty arbitrary number. The goal is what economists consider a “virtuous cycle.”
Here’s what that looks like. In times when prices are generally rising, people tend to expect them to rise further. That actually encourages people to spend money now on big durable purchases like cars or appliances to avoid having to pay more for the same thing later. The stuff we need to buy no matter what—goods like food or clothing—gets more expensive too, which requires us to spend more. Either way, companies make more money, which means more people have jobs and more of their own money to spend. And that means more demand, and therefore, higher prices. So the cycle continues.
But this bit of the cycle is crucial to its “virtue.” It’s okay if prices rise, as long as wages rise too—you’ll still be able to afford the same goods if your wages keep pace with inflation. Emphasis on the “if.” In the U.S., for two years, wage growth lagged behind inflation. That trend reversed starting in mid-2023. Wages, especially at the bottom, have kept up with inflation. In fact, in many cases, wages have surpassed inflation, and that is a good thing. We must also remember that wages in this country have been rock bottom for way too long. So, wage growth rising—good. Are wages high enough? No.
A disruption at any point in this loop can lead to the kind of high inflation we’ve experienced over the past few years. Supply chain interruptions created product shortages, and some companies artificially drove up prices to increase their profits. Along with some other causes, this effectively turned the virtuous cycle into a vicious one.
The government does have tools to combat rising inflation. They usually shift things by raising interest rates, which makes all borrowing, including credit cards and bank loans, more expensive. When the cost of borrowing goes up, it becomes more expensive to make investments or hire people, and that eventually slows the economy down. That’s what the U.S. Federal Reserve did in 2022, which did help bring inflation closer to that 2% target, while placing an even higher financial strain on families who may need to borrow just to make ends meet.
When the Fed uses interest rates to bring down inflation, they’re tamping down demand. They’re essentially telling people, “You can’t have a job,” or “Let’s put you out of work,” so demand slows, and price growth slows. The Fed raises interest rates to slow down spending across the economy, partly by signaling to markets that they’re taking the problem seriously, creating an expectation that inflation will fall. But we also have to talk about what happens when prices fall instead of rise. That’s called “deflation,” and while falling prices might sound good, they can also introduce another kind of cycle: a “deflationary spiral.”
When prices fall, consumers may hold off on making big purchases, hoping for even lower prices in the future. The stuff we need costs less, so we spend less in general. If people are spending less, companies make less money. They start cutting costs and ultimately lay off employees. Unemployed people spend less, and even those who are employed might choose to save more to stave off financial loss. So, prices go down even further as demand drops.
Ultimately, all of that adds up to slower economic growth as a whole, which is really hard to fix. Governments don’t have the same ability to respond to deflation as they do to inflation. The last time inflation dipped below 2%, in the spring of 2020, the U.S. brought interest rates all the way down to 0.05%. After bottoming out for a bit, that seemed to work—inflation inched back up. But if inflation hadn’t come back up, the government would have had limited options. Their rates were already near zero, and then things could get… dicey.
Historically, periods of true deflation are pretty rare, but when they do happen, it seems that fixing them requires a pretty serious shock to the economy. The Great Depression was, in part, a deflationary spiral solved only by the outbreak of World War II, when the government supercharged spending and employment. Japan is finally emerging from decades of chronic deflation, but that’s thanks in no small part to the high inflation most of the world battled over the last few years. You don’t want to rely on those kinds of things. If inflation goes below zero, it’s hard to fix. The cost of deflation is really high, and that’s something we want to avoid.
This is where inflation targets come in. Let’s look at this chart again. These lines are pretty shaky because there are a lot of complicated factors that affect inflation. The macroeconomy is made up of the decisions of millions of people and businesses. The way those decisions interact—it’s mind-blowing. Inflation will always fluctuate, even if just a little, and this is the last big reason why they don’t want inflation to be 0%. If inflation sits too low, that basic shakiness constantly risks dropping into the deflation zone, triggering the bad cycle.
The way to prevent that is to have it sit just a little bit higher. So, “A little inflation is usually a good thing.” Yeah, that’s annoying.”