What is commodity-backed money?
Today, most of us are familiar with fiat money – these are the nation-state currencies we all typically use in our daily lives, such as the US dollar (USD), British pound (GBP) or euro (EUR). These are issued by a government and are not backed by any physical commodity; instead, their value derives from the stability of the government that endorses them. Most forms of money in modern economies are fiat currency.
We also now have a modern alternative type of money known as cryptocurrencies – examples of these include bitcoin (BTC) and ether (ETH). Like fiat currencies, these are also not backed by any physical commodity.
Commodity-based money, on the other hand, is a kind of money that is tied to a tangible item that has some intrinsic value. Some historical examples of commodities on which money is based include precious metals such as gold, silver and copper, or foodstuffs for trading, such as tea, cocoa beans, tobacco and salt – or even large stones. For example, back in time, the majority of the Western world would have built their economies on what is known as the ‘gold standard’ – a form of commodity money in which the value of each nation’s currency was based on the purchasing power of gold.
Where have you heard of commodity-backed money?
As a relic of history, it is unlikely you have heard of commodity-backed money in any practical context. Those who have studied economic or monetary history may have come across the concept.
What do you need to know about commodity-backed money?
Commodity-backed money means the currency being used in a nation can be directly exchanged for a specific commodity. Historically and most commonly, this commodity was gold.
Simply put, commodity-backed money is money that is supported by something tangible that has an intrinsic value. You may also hear references to a commodity-backed currency, but this is essentially the same concept as commodity-backed money.
Although it is uncommon today, we can see examples of commodity-backed money throughout history. Prior to 1933, when US President Franklin D Roosevelt outlawed private gold ownership, the US economy operated according to what is known as the “gold standard”. This meant that until 1933, the US dollar was commodity-backed money, and therefore, every $1 was (in theory) exchangeable for $1 worth of actual gold.
After 1933, the US moved onto the fiat money system, where paper or coin money is only used as a medium of exchange to represent the transfer of value, but the currency has no intrinsic worth. Most of the developed world now uses fiat money.
One of the main benefits of commodity-backed money is its ability to regulate the process of inflation. In a fiat-based system, central banks are able to create as much money as they deem appropriate, while under a system of commodity-backed money, this is considerably more difficult. This is because, in theory, a commodity-backed monetary system means every $1 in the system must be accounted for by the same $1 equivalent of a commodity. This prevents you from creating more money than you have commodities to back it up with.