Commodity Money
What is Commodity Money?
Commodity money is money that has intrinsic value as a good, such as gold, silver, or salt, in addition to its use as money.
Its value comes from the commodity itself, unlike fiat money. It limits a government's ability to expand the money supply, which constrains inflation but reduces monetary flexibility.
Commodity Money: a worked example
A mint issues a coin with a face value of 1 daler containing 0.8 ounces of silver. While silver trades at 1 daler per ounce, the metal in the coin is worth 0.80 daler, comfortably under face value, so the coins circulate normally. Now silver rises to 1.50 daler an ounce. Melt value becomes 0.8 times 1.50, or 1.20 daler, which is 0.20 daler more than the coin buys as money. Holders melt or hoard the coins and pay with paper notes instead, the standard demonstration of Gresham's law: the money overvalued at the official rate keeps circulating and drives out the money that is undervalued. Notice the supply ceiling too. With 400,000 ounces of silver in the treasury and 0.8 ounces per coin, the mint can strike at most 500,000 coins, so expanding this money supply takes more metal, not a decision.
The mistake students make with commodity money
The usual mix up is calling a paper note redeemable for gold commodity money. A redeemable note is representative money, a claim ticket on metal held elsewhere, while commodity money is the metal itself: the coin you could melt, the salt block, the cigarette traded in a camp. Test any candidate by asking whether it keeps its worth if the issuer disappears overnight. A gold coin does, a redeemable note does not. The ladder worth memorizing runs commodity money, then representative money, then fiat money, each rung further from intrinsic value.
Commodity Money questions
What are examples of commodity money?
Commodity money includes gold and silver coins, copper, salt, cattle, tobacco leaf, and cigarettes traded inside prison camps. Each item was valued as a good before anyone used it to settle a debt, which is the defining test. Cigarettes qualify because even a non smoker will accept them, knowing a smoker will take them later. A paper note printed by a government fails the test, since the paper itself has almost no use value.
Does commodity money prevent inflation?
Commodity money restrains inflation but does not prevent it. The money supply can grow only as fast as new metal is mined or imported, so no government can inflate at will. When a large new deposit is discovered, though, the metal stock jumps while the quantity of goods does not, and prices rise anyway. The opposite problem hurts more. If output grows faster than the metal stock, prices must fall, and deflation raises the real burden of every debt.
Why did economies abandon commodity money?
Commodity money costs real resources to mine, guard, and transport, resources that could have produced goods instead, and coins wear down and get clipped as they change hands. The deeper problem is that the money supply tracks a mineral rather than the needs of the economy, so a central bank cannot expand credit during a recession or tighten it during a boom. Fiat money removed those costs and handed policymakers a lever over aggregate demand.
Related terms
Common comparisons
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