All you need to know about Commodity Money

We are all aware of the value of money and how essential it is to live. The economics of any nation has always been centered on its monetary system, which always changes with time. Although there are constantly new kinds of money emerging, there are two main categories of money: Fiat money and Commodity money.

 

In this article, we are going to understand what commodity money is.

 

The evolution of Money:

 

Money hasn't always developed in a linear fashion from a primitive form of money to a superior form of money and so on. In several instances in our early history, war, hunger, natural catastrophes, and other similar events have undone advances. The majority of the evolution of money occurred after the industrial revolution, just like so many other of our contemporary achievements.

 

When the Bretton Woods monetary system, in which foreign currencies were convertible into dollars at a fixed exchange rate and the dollar itself was convertible into gold at a fixed rate, collapsed in 1971, our modern fiat monetary system was born.

 

What is Commodity Money?

 

If we understand the literal meaning of ‘commodity’, we will also get what commodity money is.

 

A commodity is a physical good with inherent value as a component of production or consumption. And, an item often accepted as final payment during or after an exchange transaction is referred to as a medium of exchange. Now, money has always been a medium of exchange.

 

Commodity money is a kind of payment that has the potential to transform into a good or service for production or consumption. For instance, metals such as gold, silver, and others were used to create jewelry as well as to exchange for things in the early days. As a result, it served as a means of exchange as well as having some other worth. In the field of economics, it is called ‘intrinsic value’.

 

Commodity money is tangible; we can see, touch, and feel it. People's faith in it is ensured by its fundamental worth. This indicates that it has worth on its own since individuals freely exchange it in the confidence that it will be accepted.

 

Why was the concept of commodity money introduced?

 

In the beginning, individuals would trade items with one another after agreeing. However, it was ineffective because it lacked the transferability and distributivity that make trade effective.

 

Bartering for things is time-consuming, complex, and ineffective because it is not transferable. Finding a balance was difficult, sometimes leading to overspending on trivial necessities.

 

These issues were resolved by commodity money. Commodity money is a class of products that serve as money. These commodities were used to buy and sell other products because they had commonly recognized worth. The items that were traded had a few distinct qualities: they were in high demand and consequently valuable, but they were also strong, lightweight, and convenient to store.

 

Commodity money has a long history that spans millennia and centuries. In actuality, pinpointing its origin is very impossible. However, some documents show activity between 700 and 500 BC, when gold was a prevalent form of currency.

 

What are the Characteristics of Commodity Money?

 

Here are the characteristics that made people trust commodity money:

 

1. Commodity money is durable:

 

Meat and other commodities wouldn't work since they spoil over time. Iron, for example, would not be sufficient since it rusts rapidly. The faith in the commodity won't persist if it is unable to maintain its fundamental worth.

 

Metals like copper, gold, and silver were durable and hence used as a currency.

 

2. Commodity money is easily exchangeable:

 

No one wants to deal with the hassle of buying a cow at the market. Gold coins are significantly more practical because they are lightweight and simpler to carry. All of the historically successful commodities are convenient and simple to trade.

 

3. Commodity money is measurable:

 

Money must be measured in a precise way. This was made possible by the invention of units of measurement like ounces and pounds. We can buy various things at various rates as a consequence. Money cannot be measured, thus it is impossible to determine how much we are willing to spend.

 

4. Commodity money is rare:

 

Because there is a finite quantity, commodity money must be uncommon. Without them, the amount of money available can practically become limitless, which would result in extremely high inflation. The money supply must, nonetheless, be able to respond to rising economic production. In other words, the ability of the commodity supply to respond to rising demand is required. Therefore, the commodity must be able to provide and represent the new items in the market as the economy begins to develop.

 

Examples of Commodity Money:

 

Some examples of commodity money are:

 

1. Gold

2. Copper

3. Salt

4. Silver

5. Tea

6. Alcohol

7. Sea shells

8. Cacao nuts

9. Cigarettes

10. Wheat

 

Advantages and disadvantages of Commodity Money

 

Like every other type of money, commodity money has benefits and drawbacks.

 

Commodity money has the following primary advantages:

 

• Commodity money has an additional or supplemental function. For instance, cigarettes may be smoked in addition to serving as a kind of commodity money, whereas gold and silver can be used to fashion jewelry.

 

• The goods used to create commodity money retain their worth. We might claim that the supply of commodity money is constrained by design.

 

• Since commodities have a value of their own, unlike currencies, they can be utilized as a buffer during periods of excessive inflation.

 

Disadvantages of commodity money:

 

• It is exceedingly difficult to divide or divide up commodity money according to one's requirements. It is impossible to break down commodities like cattle or gold bars into smaller pieces for ordinary transactions.

 

• Although the value of commodities is often less erratic, there is always a chance that their value might decrease. Although gold is a precious commodity, its cost can fluctuate over time. As a result, commodities money always carries a risk of volatility.

 

• Because it is challenging to ascertain whether the value of the purchased item is equivalent to the price of products exchanged as commodity money, valuing items acquired using commodity money is particularly challenging.

 

How did people start trusting Commodity money?

 

A key component in developing a commodity's confidence is its "intrinsic worth." We can go back many centuries to a time when commodities like salt or tobacco were utilized as currency. 

 

They have widely used items, therefore people would exchange them for them. Even if nobody wanted to take it, the owner may still utilize it. Therefore, if someone brought a pound of tobacco to the market and no one would buy it, they would be permitted to smoke it.

 

Over time, faith in commodities grew gradually. Although traders might not embrace it, the populace was comforted to learn that it had further applications. The scarcity of commodity money, or at least how it is viewed as scarce, contributes to some of the faith in it. The inherent worth of commodities like gold is increased by their rarity, which makes them more desirable.

 

Contrarily, we also have commodity currencies that depend on production and consumption, such as salt and tobacco. To put it another way, how supply might be limited. Such products weren't particularly efficient. There was, nonetheless, some level of confidence in them. This was due to the supply's temporary self-regulation.

 

The fact that the supply will soon exceed the demand presented a fundamental problem, though. It was a kind of money, thus inflation was certain to follow.

 

How is Commodity Money different from Fiat Money?

 

A fiat currency is a legal claim since the law grants it all of its attributes. Similar to a purchase voucher, it has a variable purchasing power and may be exchanged for products and services. Debt settlement is the sole fixed right connected to fiat money.

 

Fiat money does not need any physical commodity backing it up. It was initially created as a practical way for citizens to carry paper that was backed by the government rather than lugging about gold or silver. 

 

Government fiat money has lost its initial worth as a result of governments' decreasing willingness to back it up with gold or other commodities throughout time. Government fiat money has lost its initial worth as a result of governments' decreasing willingness to back it up with gold or other commodities throughout time.

 

Contrarily, commodity money is money that gets its worth from the commodity from which it is created. On-demand, it can be traded for a certain good. For instance, items like copper, gold, silver, big stones, alcohol, tobacco, cigarettes, cocoa beans, and barley are utilized as a form of commerce. 

 

An excellent example of commodity money where individuals are not required to carry gold while transacting in products is the gold standard. If a gold coin is produced, its worth would be determined by the price of gold rather than by its face value. Commodity money was created as a practical means of exchange because it outperformed the barter trading system.

 

The disadvantage of commodity money is that it faces a lot of fluctuations in price. 

 

Commodity money is regarded as a current good. Fiat money, on the other hand, is just a promise to pay in the future, making it a future obligation. When it comes to fiat currency, payment is never made; instead, it is only discharged. Contrarily, commodity money completes the deal. A commodity-based monetary system requires that the final payment always be given in the form of the commodity that was used as payment for the transaction. Since there is no obligation and receiving the commodity in payment terminates all other commitments, the commodity is used as a final payment.

 

Advantages of Gold over Fiat Money:

 

Given that gold is the ultimate commodity money, it is important to think about whether it is better than the fiat money we now use.

 

• The fact that the quantity of gold is steady has the extremely important virtue of preventing governments or banks from artificially inflating the money supply.

• Since gold has true inherent worth, it is unlikely to ever lose all of its value, as has occurred to every fiat currency throughout history.

• For 50 years, from 1870 to 1920, the Gold Standard, a monetary system in which legal currency could be exchanged for gold coins, characterized the western world. This time period saw unparalleled economic development and stability.

 

Disadvantages of Gold as currency:

 

Because it is less portable than fiat money in the current day, gold is not a good choice for commodities money. It is not practical to need actual gold in lieu of a credit/debit card for payment. Of course, this might be easily avoided by printing paper money and credit money that can be converted into gold at a set rate, but this would be a representational money rather than a rigid commodity money.

 

Because of its steady supply, gold cannot be produced at a rate quick enough to keep up with new economic expansion. According to the inference, we would have to tolerate persistent deflation (dropping prices for goods and services), which would restrain economic growth rates.

 

Also Read | Time Value of Money: Concept, Formula and Benefits

 

Conclusion:

 

The initial kind of money used by people to buy goods and services was a commodity, and even today, central banks still hold gold, the ultimate commodity money, as part of a diverse portfolio of financial assets that make up their official reserves.

 

Modern fiat money is primarily reliant on its acceptance as a means of commerce and lacks the intrinsic worth that commodities do. All previous attempts to keep a fiat currency in circulation have failed, frequently with terrible results and ultimately leading to a return to commodity money.

 

If our existing fiat system falls, new representational money, not rigid commodity money, would probably take its place.