The Functions of Money: Commodity Money

Commodity Money When you think of money you probably think of the green dollar bills and coins that are used as currency in the United States. Yet throughout history a variety of commodities have been used as money. Commodity money is an item that serves the functions of money but also has intrinsic value as a marketable item in addition to its value as the medium of exchange. In the early days of America, tobacco, corn, and other agricultural commodities were accepted as payment for goods and services. Gold and silver were most commonly used by European and other nations as money throughout much of their history. Many strange items crop up as commodity money. For example, furs were used as money in ancient Russia. Sometimes stamped pieces of leather were used as tokens of the furs and circulated as money. The Zulus of South Africa used cattle as money. The American Indians used wampum, a form of money consisting of trinkets made out of shells. Recently in Rumania, Kent cigarettes were used as money for black market transactions! It had to be Kent; no other brand would do! The packs were exchanged unopened; no one would even dream of smoking the cigarettes inside. A Rumanian lighting up a Kent in the mid-1980s would have been considered as crazy as someone who burns dollar bills in the United States. Fiat Money Fiat money is money that is accepted as a medium of exchange because of government decree rather than because of its intrinsic value as a commodity. The dirty dollar bill in your pocket is really just a piece of high-quality 100-percent rag paper whose market value is virtually nil. You value it because you know that it will be accepted for a dollar's worth of goods and services at current prices. In the past, U.S. coins were made of silver. However, as the market price of silver increased, the market value of silver in those coins increased to more than their face value. This meant that a 50-cent piece had more than 50 cents worth of silver in it (see Principles in Practice box). Under such circumstances it would have been profitable to melt down the coins into silver bullion because the coins were more valuable as raw silver than as money! Now the market value of the metal in a quarter is only a fraction of a cent. Paper money was apparently invented by the Chinese in the 13th century. If you're fortunate enough to have some paper money in your wallet, pull out a bill and look at it closely. You'll observe, on the dark-colored side, on top of the picture of a famous American, that the bill is a "Federal Reserve Note." This means it's issued by one of the 12 regional banks of the Federal Reserve System, the central banking system of the United States. Toward the upper left corner you'll see "THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRI-VATE," a proclamation (or decree) by the government that this piece of paper is the legal medium of exchange in the United States. In effect, whenever you purchase an item you incur a debt to the seller. You can pay off your debt immediately with Federal Reserve notes, which serve as fiat money in the United States. Fiat money, like Federal Reserve notes, can serve the functions of money simply because it's generally accepted in exchange for goods and services. Again, look atthe legal medium of exchange in the United States. In effect, whenever you purchase an item you incur a debt to the seller. You can pay off your debt immediately with Federal Reserve notes, which serve as fiat money in the United States. Fiat money, like Federal Reserve notes, can serve the functions of money simply because it's generally accepted in exchange for goods and services. Again, look at a Federal Reserve note. Nowhere on the note will you find any promise that it will be redeemed by the Federal Reserve banks for gold, silver, or anything else. Of course, if you take a $20 bill to the Federal Reserve bank, you may be able to exchange it for two $10 bills. You can also use your money to buy gold or silver as you would use it to buy any commodity. Technically Federal Reserve notes are a liability (or debt) of the Federal Reserve banks. You'll see in the chapter on the Federal Reserve System that the liabilities of the Federal Reserve banks are balanced by their assets, which include government bonds and some gold. However, by law the Federal Reserve banks are not required to exchange Federal Reserve notes held by the public for anything other than more currency (either paper money or coins). Monetary authorities in central banks must be careful to keep confidence in money. When the public loses confidence in the official money of a nation, they seek alternative forms of money. Its functions as a medium of exchange, standard and store of value, and standard of deferred payment are impaired. If you thought rampant inflation was on the way, you wouldn't want to hold any money, and whenever you got some you'd quickly exchange it for some commodity whose value would keep up with the inflation rate.