Commodity Money

Commodity money is any money that is both used as a general purpose medium of exchange and as a tradable commodity in its own right.An example is coins made of precious metal.Commodity-based currencies are often viewed as more stable, but this is not always the case. The value of a commodity-based currency as a medium of exchange depends on its supply relative to other goods and services available in the economy. Historically, gold, silver and other metals commonly used in commodity-based monetary systems have been subject to regular and sometimes extraordinary fluctuations in purchasing power. This not only damages its stability as a medium of exchange; it also reduces its effectiveness as a store of value. In the 1500s and 1600s huge quantities of gold and even larger amounts of silver were discovered in the New World and brought back to Europe for conversion into coin. As a result, the purchasing power of those coins fell by 60% to 80%, i.e. the prices of goods rose, because the supply of goods did not keep pace with the increased supply of money.In addition, the relative value of silver to gold shifted dramatically downward. Such discoveries of huge sources of gold or silver are a thing of the past, and lend to their supply stability. More recently, from 1980 to 2001, gold was a particularly poor store of value, as gold prices dropped from a high of $850/oz. ($27.30 /g) to a low of $255/oz. ($8.20 /g), although this figure is now back to almost $750 per ounce as of late 2007.It should be noted that gold was not a currency at this time, and was fluctuating due to its status as a final store of value — that is, the price never goes to zero as fiat currencies may (in theory). The advantage of gold and silver, however, lies in the fact that, unlike fiat paper currency, the supply cannot be increased arbitrarily by a central bank.

It is also possible for the trading value of a commodity money to be greater than its value as a medium of exchange when governments attempt to fix exchange rates between different commodity moneys. When this happens people will often start melting down coins and reselling the metal used to make them. This has happened periodically in the United States, eventually causing it to move away from pure silver nickels and pure copper pennies.Shipping coins from one jurisdiction to another so that they could be reminted was sometimes a lucrative trade before the advent of trusted paper money

.Commodity money's ability to function as a store of value is also limited by its nature. For example, copper and tin risk rust and corrosion, and gold and silver are soft metals that can lose weight through scratches and abrasions.

Stability aside, commodity-based currencies may have a tendency to restrain growth in a very active economy. For example, in order to maintain the price level, the supply of money in an any economy must be equal or greater than the volume of goods and services produced.