Commodity money: Meaning, Criticisms & Real-World Uses

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What Is Commodity Money?

Commodity money is a type of money whose value comes from the commodity of which it is made. In the realm of financial economics, commodity money consists of objects that have an intrinsic value beyond their use as currency. These items are valued for their utility or beauty as goods in themselves, making them distinct from other forms of money that derive their value purely from government decree or a claim on a commodity.

History and Origin

The earliest forms of money were commodities, such as cattle and grain, which came to be used as a medium of exchange and store of value. Over time, precious metals, especially silver and gold, became dominant forms of payment due to their portability, durability, homogeneity, and verifiability. Early forms of commodity money were often weighed rather than counted. The introduction of coins stamped with their weight and purity further streamlined transactions, reducing costs associated with trading.¹²

Salt, for instance, played a significant role as a commodity money in various ancient civilizations, including the Roman Empire, where soldiers were sometimes paid in salt, giving rise to the word "salary."¹¹ In parts of ancient Africa, particularly during the Trans-Saharan trade era, salt was so valuable that it was exchanged for gold dust, sometimes at a pound-for-pound rate.¹⁰ The economic importance of salt extended beyond trade; control over salt mines and trade routes became a source of power for empires like Ghana, Mali, and Songhai.⁹

Between the 1870s and World War I, and in some cases into the Great Depression, many nations backed their currencies with gold, a system known as the gold standard.⁸ The International Monetary Fund (IMF), established in 1944, initially operated on a modified gold standard, where countries set legal gold valuations for their currencies.⁷ However, the fixed currency system tied to gold ended in 1973.⁶

Key Takeaways

Commodity money derives its value from the material it is made from, possessing intrinsic utility or beauty.
Historically, items like gold, silver, salt, and even cigarettes have served as commodity money.
Its use predates modern monetary systems based on representative or fiat money.
The transition from commodity money to other forms was often driven by efficiency and convenience.
Commodity money is fundamentally different from barter as it establishes a recognized unit of exchange.

Interpreting Commodity Money

Understanding commodity money involves recognizing that its value is inherent to the object itself, rather than being assigned by government decree or a promise of convertibility. This direct value perception by users is a key characteristic. For example, if gold is used as commodity money, its value is derived from its uses in jewelry, industry, or as a rare metal, not solely because a government declares it currency.

In an economy operating with commodity money, the stability of the currency is directly tied to the supply and demand of the underlying commodity. An increase in the supply of the commodity, such as a new discovery of gold, could lead to inflation, as more money chases the same amount of goods and services. Conversely, a decrease in supply could lead to deflation. This direct link to a physical commodity can influence economic stability.

Hypothetical Example

Imagine a remote, self-sufficient community where apples are abundant but relatively perishable, and durable, easily divisible stones are scarce. Initially, people might barter apples for other goods. However, if the community decides to use a type of stone as commodity money, these stones would become the accepted medium of exchange. A farmer needing new tools could offer a certain number of stones for them, and a craftsman would accept the stones knowing they could later be exchanged for food, clothing, or other necessities. The stones have an intrinsic value due to their rarity and their use in construction or art within the community. The community establishes the stones as a recognized unit of account, making transactions more efficient than direct bartering.

Practical Applications

While pure commodity money systems are largely historical, the principles behind commodity money continue to influence modern financial thought. The concept of backing a currency with a tangible asset, such as gold, remains a topic of discussion in monetary policy debates, albeit a minority view. For example, discussions around reviving the gold standard periodically emerge, often rooted in the perceived stability and independence from government manipulation that a commodity-backed system might offer.⁵

The transition from commodity money to representative money (like paper money redeemable for gold) and then to fiat money (currency not backed by a physical commodity) illustrates the evolution of financial systems. Today, the money supply in most countries, including the United States, consists primarily of fiat money, such as Federal Reserve Notes, which are backed by the financial assets pledged by the Federal Reserve Banks, mainly Treasury securities., The Federal Reserve, as the central bank of the United States, manages this money supply to influence economic conditions.

Limitations and Criticisms

One of the primary limitations of commodity money is its inherent scarcity and the difficulty in scaling its supply to meet the needs of a growing economy. If the supply of the chosen commodity cannot easily expand, it can hinder economic growth and lead to deflationary pressures. For instance, a fixed supply of gold under a pure gold standard can restrict the overall liquidity in the financial system. Historically, a withdrawal of gold from the banking system under the gold standard could lead to severe economic restrictions and even bank runs.⁴

Another criticism is that the value of commodity money can fluctuate based on factors unrelated to its monetary function, such as changes in mining technology for metals or agricultural output for grains. This can introduce volatility into the economy. Furthermore, the cost of producing, storing, and securing physical commodities as money can be substantial. The temptation for governments to debase commodity coinage by reducing the proportion of the valuable metal in an attempt to generate revenue (seigniorage) was a historical problem that often led to inflation.³

Commodity Money vs. Fiat Money

The primary distinction between commodity money and fiat money lies in the source of their value. Commodity money derives its value directly from the material it is composed of, meaning the commodity itself has inherent utility or desirability. Examples include gold, silver, or even historical instances of salt or beaver pelts used as currency. Its value is recognized by users because the commodity is a useful good in itself.

In contrast, fiat money has no intrinsic value; its value is derived solely from government decree and the public's confidence in that decree. Modern paper currencies, such as the U.S. dollar, are prime examples of fiat money. Their value is not tied to a physical commodity but rather to the issuing government's credibility and its management of the economy. The Federal Reserve, for example, issues Federal Reserve Notes as legal tender without them being convertible into a specific commodity. The acceptance of fiat money relies on trust in the monetary authority and its ability to maintain purchasing power through sound monetary policy.

FAQs

What are some historical examples of commodity money?

Historically, common examples of commodity money include gold, silver, copper, salt, shells, tobacco, and even cigarettes in some post-war scenarios.², These items were chosen because they possessed qualities like durability, divisibility, and general acceptance.

Why did societies move away from commodity money?

Societies moved away from commodity money largely due to its limitations, such as scarcity, weight, storage issues, and difficulties in scaling the money supply to match economic growth. The transition to representative money (paper claims on commodities) and then to fiat money offered greater flexibility, portability, and ease of management for national economies.

Does commodity money still exist today?

Pure commodity money systems are rare in modern economies. While some items might be exchanged for their intrinsic value in informal or niche markets, the dominant form of currency globally is fiat money. However, some valuable commodities, like gold, continue to serve as a store of value and an investment, influencing financial markets and policies.

What are the three functions of money, and how does commodity money fulfill them?

Money typically serves three functions: a medium of exchange, a unit of account, and a store of value. Commodity money fulfills these functions because the commodity itself can be traded for goods and services (medium of exchange), its quantity can be used to price other items (unit of account), and it can be saved for future use without significant loss of value (store of value).¹