Money in modern economies is mostly bank debt, and thus
the market for money balances can be considered as part of
financial markets. However, past societies used commodity
monies, that is, the thing they used as money was
valuable both as a money and for some other purpose. Gold
and silver have been popular commodity monies, and
cigarettes in the POW camps of WWII are another example.
With a commodity money, the market for money balances is
part of the markets for goods and services.
The quantity theory suggests that a society that uses a
commodity money will be subject to disturbances that are
different from those that affect a society using bank-debt
money. This difference exists because the forces that
determine the amount of a commodity money are different from
those that determine a credit money. An examination of how a
system of commodity money works can be done with supply and
demand analysis, and it points out some important
predictions of the quantity theory.
A commodity money can give rise to a large amount of price instability if either there are large changes in the supply of the commodity or there are large changes in the
nonmonetary use of the commodity. An example of a commodity
money that gave rise to price fluctuations is the cigarette
currency used in POW camps in the Second World War. The
price of goods in terms of cigarettes depended on the
relative availability of cigarettes and goods. If no
cigarettes were received in the camp for some time, the
supply of them would diminish (because prisoners would use
them as commodities: they would smoke them) and their value
would rise. A rise in the value of cigarettes meant that
cigarettes bought more, or that prices fell. When a shipment
of cigarettes would arrive, their increased availability
would cause their value to drop, which meant prices would
rise. In his description of the system, R.A. Radford stated
that the erratic delivery of cigarettes and the resulting
waves of inflation and deflation were a major problem in the
mini-economy of the POW camp.1
In comparison to cigarettes, gold and silver have been
stable monies. There have only been a few times when the
amount of these metals changed rapidly. The largest change
was probably the influx of gold and silver into Europe after
the Spanish looted the Aztecs and Incas.
Perhaps the biggest problems with gold and silver monies
have occurred when governments debased them. For example,
ancient Rome had a commodity money based on gold and silver.
When the emperors in the second and third centuries needed
more funds, they often reduced the amount of gold and silver
in their coins. As a result, by the end of the third
century, Roman coins had virtually no precious metal in them
and the Roman empire had serious inflation as the mints
churned out worthless coins. However, a monetary reform at
the beginning of the fourth century lead to a stable
monetary system that lasted almost a thousand years as part
of the Byzantine empire.
Commodity monies have some desirable characteristics. The
fact that the money also has a commodity use and is produced
as a commodity can help dampen the effects of sudden
changes. For example, suppose that the amount of a commodity
money suddenly doubles. Ignoring the commodity aspect of the
money, the quantity theory says that this change should cut
the value of the money by one half (which means that the
price level should double). When the money is a commodity
money, there are three reasons that this prediction may be
wrong and that a commodity money will provide more price
stability than a money not based on a commodity.
First, the reduced value of the money will encourage
people to use the item more in its commodity use. For
example, if gold serves as money, and its value drops,
people will increase their use of gold for jewelry,
tableware, and artistic purposes. Their actions will reflect
the law of demand: whenever a commodity becomes cheaper,
people use more of it. Thus if there is a sudden influx of
gold into a country that uses it as money, part of the
influx will be diverted to its commodity use, and the
effects on the amount of money, and hence on the price
level, will be lessened. On the other hand, a sudden decline
will also be cushioned, because as the commodity grows more
valuable, people will transfer it from its commodity use
into a monetary use. If the amount of gold declines and it
rises in value, there is an incentive to melt down jewelry,
tableware, and artistic objects and use the gold as money.
Hence a doubling of gold may not double the amount of money,
and cutting the amount of gold by one half may not cut money
by one half.
Second, if money falls in value, the incentive to produce more of it is cut and if it rises in value, the incentive to produce more of it is raised. If the value of gold increases, more people will try to find it, and if its value declines, fewer people will search for it.
The third reason takes us into the realm of international economics.
1 R.A Radford, "The Economic Organization of a P.O.W. Camp," Economica, XII (Nov., 1945), pp. 189-201. An online copy may be found at http://www.oddgods.com/articles/2006n24a
Copyright Robert Schenk