Commodity Money: Advantages and Historical Significance

Nations use two different types of currency to denominate transactions occurring within their borders: fiat money and commodity money. Fiat money derives its value from the fact that everyone agrees it is worth something, while commodity money derives its value from the fact that the government ties each unit of currency to a certain amount of a commodity with its own intrinsic value. A commodity money system enjoys various advantages that a fiat system does not.

No Seigniorage

Seigniorage is the practice of printing new money specifically for the sake of using it to purchase goods and services. While seigniorage allows governments to quickly enact public policy and build infrastructure, it also lowers the value of the currency already in the economy. The real effect of seigniorage is essentially the same as that of a tax, as it forcibly reallocates resources. Used sparingly, seigniorage can be useful, with negligible negative effects to an economy. When used heavily, though, seigniorage can destroy the value of a nation's currency. In a commodity money system, seignorage is impossible because the government cannot simply create the commodity that backs the currency.

Savings

Neither a fiat or commodity monetary system can keep the value of money from changing. However, economists tend to view deflation (appreciation of currency value) as being even more harmful to an economy than inflation (depreciation of currency value). This is because deflation gives incentive for people to save their money, while inflation gives incentive for people to save or invest their money. For this reason, governments on a fiat system tend to target a trend of general inflation by continually printing extra money. Commodity systems often result in deflation because the supply of the commodity that backs the currency tends to grow more slowly than the economy as a whole. While such deflation can be harmful to economies in other ways, it is beneficial to those who save their money, as they can see their wealth increase with no effort or risk on their part.

Nonpolitical Value

When a government uses a fiat currency, the value of that currency comes from the amount in circulation and from the faith that people have in the government. However, if the government becomes unstable or falls, the value of that currency can evaporate. If that nation uses commodity money, even if the government becomes unstable or falls, the value of the currency remains.

Misconceptions

A common misconception about having a commodity money system is that it results in a constant value for currency. In reality, though, the value of commodity money is no more stable than the value of the commodity that denominates it. Prices always fluctuate, resulting in fluctuations in the value of commodity money. Another misconception is that the general trend of inflation found in fiat systems will always destroy an economy. In reality, as long as inflation occurs at low, stable levels, the gradual loss of currency value is something that an economy can easily account for.