The Role and Kinds of Money, Part 3
Question 1: Describe commodity money.
Answer 1: Any form of money that receives value from the intrinsic worth of the material from which it is made is known as commodity money. The earliest forms of money—such as gold, jewels, salt, and rice—are all commodity monies. In order for these substances to be used as money, they must be scarce within the society useful to most of the members of the society. Commodity money made of precious minerals or metals must contain enough of the valuable substance to justify the money’s face value. One problem with commodity money is that in times of extreme scarcity, people hoard coins rather than spend them. This hoarding puts a damper on economic activity.
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Question 2: Describe representative money.
Answer 2: Money that is intrinsically worthless but backed up by a valuable substance is called representative money. One example of representative money is paper bills tied to the federal government’s gold holdings. In such a system, the amount of paper money cannot exceed the amount of gold held by the government. Systems of representative money were popular during the medieval period, when merchants and gold dealers would issue receipts promising to exchange specific amounts of gold for paper bills. Because representative money is tied directly to gold reserves, it is subject to fluctuations in value. Eventually, economists decided to move away from this system because they felt controlling inflation and deflation was impossible.
Question 3: Describe fiat money.
Answer 3: Fiat money has no intrinsic value, and it is not directly tied to the reserves of the federal government. Essentially, fiat money acquires its value by direct order of the federal government. For this reason, fiat money is only valuable when members of the economy trust the word of the federal government. The United States uses fiat money, as indicated by the statement, “this note is legal tender for all debts, public and private” printed on dollar bills. The United States federal government in effect guarantees the bill’s value, even though the money is not backed directly by gold or silver reserves. Using fiat money gives the federal government more control over the monetary supply, although some economists claim using fiat money leaves the currency vulnerable to inflation.
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