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Commodity Monies

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.

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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
Copyright Robert Schenk