Commodity money system
A commodity money system is a monetary system in which a commodity such as gold is made the unit of value and physically used as money. The money retains its value because of its physical properties. In some cases, a government may stamp a metal coin with a face, value or mark that indicates its weight or asserts its purity, but the value remains the same even if the coin is melted down.
One step away from commodity money is "commodity-backed money", also known as "representative money". Many currencies have consisted of bank-issued notes which have no inherent physical value, but which may be exchanged for a precious metal, such as gold. (This is known as the gold standard.) The silver standard was widespread after the fall of the Byzantine Empire, and lasted until 1935, when it was abandoned by China and Hong Kong.
The alternative to a commodity money system is fiat money which is defined by a central bank and government law as legal tender even if it has no intrinsic value. Typically fiat money is paper currency or base metal coinage, but it can also exist as data such as bank balances and records of credit or debit card purchases.
In the modern economy most money is held as deposits in banks, and the fraction that exists as currency (notes and coins) is relatively small. Money is mostly created, contrary to what is written in most textbooks, by banks when they loan to customers. Put simply, banks lending currency to customers creates more deposits and deficit spending.
In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits. Although commercial banks create money through lending, they cannot do so freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system. Prudential regulation also acts as a constraint on banks’ activities in order to maintain the resilience of the financial system. And the households and companies who receive the money created by new lending may take actions that affect the stock of money – they could quickly ‘destroy’ the money or currency by using it to repay their existing debt, for instance.
Central banks control the creation of money by commercial banks, by setting interest rates on reserves. This limits the amount of money the commercial banks are willing to lend, and thus create, as it affects the profitability of lending in a competitive market. This is the opposite of what many people believe about the creation of fiat money. The most common misconception was that central banks print all the money, this is not reflective of what actually happens.
Today's global monetary system is essentially a fiat system because people can use paper bills or bank balances to buy goods.
- International monetary systems
- Monetary economics
- Monetary policy
- Money supply
- Price system
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- Brent Radcliffe. "Fiat Money". Investopedia. Retrieved 25 April 2015.
- "Money creation in the modern economy: an introduction" (PDF). Bank of England.
- "Money creation in the modern economy" (PDF). Bank of England.
- "How the Fiat System Works". dummies.com. Retrieved 25 April 2015.