Is fiat money more prone to inflation than commodity money? (2024)

The value of fiat money is based largely on public faith in the issuer. Commodity money's value, on the other hand, is based on the material it was manufactured with, such as gold or silver. Inflation refers to the tendency for prices to rise in an economy over time, making the money in hand less valuable as it requires more dollars to buy the same amount of goods. This reduction in purchasing power is seen as a monetarist cause of inflation. While other theories and causes of inflation do exist, the idea that changes to the money supply influence price levels has a bearing on commodity vs. fiat monies.

Fiat money does not have intrinsic value, while commodity money often does. Changes in public confidence in a government issuing fiat money may be enough to make the fiat currency worthless. Commodity money, however, retains value based on the metal or other material content it has. Fiat money is, therefore, more at risk of inflation because its value is not intrinsic.

Key Takeaways

  • Inflation measures the rate at which the average price levels in an economy increase over time.
  • Monetarist theory suggests that inflation is alternatively the reduction in the purchasing power of a unit of currency in an economy.
  • Commodity money has some intrinsic value due to the content of precious metal it is made up of or backed by, but debasem*nt or increases in precious metal supply can cause inflation.
  • Fiat money is backed only by the faith of the government and its ability to levy taxes. Since it does not have an intrinsic value per se, it can be more prone to this kind of inflation as more can be printed at will.

Commodity Money and Inflation

Commodity money has intrinsic value but risks large price fluctuations based on changing commodity prices. If silver coins are used, for instance, a large discovery of silver may cause the value of the silver currency to plunge, resulting in inflation.

As a historical example of this phenomenon, when the Spanish explorers discovered a bounty of gold and silver and started mining ore out of the New World in the 16th and 17th century, the sudden influx of gold and silver caused rampant inflation in Spain due to the sudden increase in the nation's precious metal supply.

Another way that commodity money sees inflation is through the debasem*nt of the currency. Debasem*nt means that money, typically metal coins, is devalued because there is less precious metal in the coin than the value stamped on its face. Governments may debase coins by adding copper, tin, or other less valuable alloys to coins as they are minted, while still saying they are worth (e.g., $1 in exchange).

Individuals may also debase gold or silver coins by clipping the edges or filing off shavings from coins, melting those small amounts down, and selling them. This results again in coins in circulation that contain less precious metal than indicated.

Fiat Currency and Inflation

For convenience and to avoid these price changes, many governments issue fiat currency. Fiat money is a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it as is the case for commodity money.

Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies.

Initially, many fiat currencies were backed by a commodity. Backing a fiat currency with a commodity provides more stability and encourages confidence in the financial system. Anyone could take backed fiat currency to the issuing government and exchange it for a certain amount of the commodity.

Eventually, many governments no longer backed fiat currency, and the money increasingly took on a value based on public confidence. As of 1933, U.S. citizens could no longer exchange currency with the U.S. government for gold. In 1971, the U.S. stopped offering foreign governments gold in exchange for U.S. currency. Many governments no longer think commodity money is in the best interests of the public.

Because fiat money is not linked to physical reserves, such as a national stockpile of gold or silver, it risks losing value due to inflation or even becoming worthless in the event ofhyperinflation. If people lose faith in a nation's currency, the money will no longer hold value. That differs from currency backed by gold, for example; it has intrinsic value because of the demand for gold in jewelry and decoration as well as the manufacture of electronic devices, computers, and aerospace vehicles.

Example

The African nation of Zimbabwe provided an example of the worst-case scenario in the early 2000s. In response to serious economic problems, the country's central bank began to print money at a staggering pace. That resulted in hyperinflation, which ran between231 million and 489 billion percent in 2008. Prices rose rapidly and consumers were forced to carry bags of money just to purchase basic staples.At the height of the crisis, one U.S. dollar was worth about 8.31 billion Zimbabwean dollars.

Is fiat money more prone to inflation than commodity money? (2024)

FAQs

Is fiat money more prone to inflation than commodity money? ›

Changes in public confidence in a government issuing fiat money may be enough to make the fiat currency worthless. Commodity money, however, retains value based on the metal or other material content it has. Fiat money is, therefore, more at risk of inflation because its value is not intrinsic.

What are the advantages of fiat money over commodity and representative money? ›

Pros of fiat money

Unlike gold, Fiat money is not backed by a commodity, meaning it's not limited or scarce. For this reason, a government has greater control over the currency supply, which can give it the power to manage economic variables such as interest rates, liquidity and credit supply.

Which best explains the difference between fiat money and commodity money? ›

Fiat money has no value except as​ money, whereas commodity money has value independent of its use as money.

What is the main disadvantage of commodity money? ›

One of the main disadvantages of commodity money is that it can be difficult to transport and store. Precious metals like gold and silver are heavy and can be cumbersome to transport and store. This can make it difficult to use commodity money in large transactions.

Why is fiat currency more vulnerable to dramatic economic shifts than currency on the gold standard? ›

Fiat currency, distinguished from the gold standard, is a type of currency that is issued by a government and is not backed by a physical commodity like gold. Instead, its value relies on the trust and confidence of those who use it. As a result, fiat currency is more susceptible to dramatic economic shifts.

Why is fiat money better than commodity money? ›

Commodity money has some intrinsic value due to the content of precious metal it is made up of or backed by, but debasem*nt or increases in precious metal supply can cause inflation. Fiat money is backed only by the faith of the government and its ability to levy taxes.

What is a disadvantage of fiat money? ›

Disadvantages of fiat currency

Inflation risk: Because fiat money is not backed by a physical commodity, governments can print more money, which can lead to inflation. Dependence on government stability: The value of fiat money is closely tied to the stability and credibility of the issuing government.

How does fiat money affect inflation? ›

Governments use fiat money to create economic stability and help protect against the booms and busts that are natural parts of the business cycle. The overproduction of fiat money risks inflation or even hyperinflation by increasing supply beyond demand, however.

What was the problem with commodity money? ›

A chief issue with commodity money was quality. People tended to utilize or sell their best products while offering their poorest goods as commodity money. Even some commodities of good quality would deteriorate if kept too long.

What are the advantages of commodity money? ›

The primary advantage of commodity money is that commodities tend to have greater intrinsic value. Further, because of this intrinsic value, commodity money is not as susceptible to inflation as fiat money is. Finally, commodity money may be less susceptible to government regulation.

What is one difficulty with using commodity money? ›

Commodity money is known to have volatility risk. Its value is affected by supply and demand. For instance, if oil is used as money, its value will increase significantly when there is a natural event that disrupts its supply. Also, when the demand for oil goes down, its value will fall.

What was one major problem of commodity money ___________? ›

One of the major problems with commodity money was quality. Individuals tended to use or sell their best products while their poorest products would be offered as commodity money. Additionally, even good quality commodities would deteriorate if retained too long.

What is commodity advantage and disadvantage? ›

The benefits of commodity market investments include lower volatility, hedging against inflation or geopolitical events, diversification, etc. And, the disadvantages of commodity market trading include high leverage, excessive volatility, higher dependence on macroeconomic factors, etc.

Which most accurately explains why fiat money differs from commodity money? ›

Commodity money has value in itself while fiat money has value only because it is given value.

What currency is backed by gold? ›

Narrator: The United States ended its attachment to the gold standard in 1971, converting to a 100% fiat money system. Today, there isn't a single country that backs its currency with gold.

What is the US dollar backed by? ›

Prior to 1971, the US dollar was backed by gold. Today, the dollar is backed by 2 things: the government's ability to generate revenues (via debt or taxes), and its authority to compel economic participants to transact in dollars.

What is the advantage of fiat money system? ›

Fiat money gives governments greater flexibility to manage their currency, set monetary policy, and stabilize global markets. It also allows for fractional reserve banking which lets commercial banks multiply the amount of money on hand to meet demand from borrowers.

What is the great benefit of a fiat money quizlet? ›

Fiat currencies let governments deal with economic problems by increasing or decreasing the money supply.

What is the difference between commodity money and fiat money quizlet? ›

What is the difference between commodity money and fiat money? Commodity money involves the use of an actual good in place of money (gold coin, tobacco). Fiat money has no other value than as a medium for exchange; value comes from government (paper money).

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