Fiat and Commodity Backed Money

Fiat Money is where the quantity of money that can be printed is unlimited, as it is not attached to a fairly fixed commodity. Despite being legal tender, the country need not hold it’s worth in commodity.

Commodity Backed Money is where the quantity of money is backed with a commodity, which it can be traded in with at request. The money supply cannot increase past the worth of commodity the country holds. The Gold Standard was the best example.

The Problems of Fiat Money

Hyperinflation: A case study has found that economies which have unbacked money have suffered periods of hyperinflation, with Peter Schiff predicted the US will have the same fate. Often this is because of the incentive to print more money to get the government out of debt.

Moral Hazard: With the power to increase the money supply to get itself out of debt, the government is protected against the risk of default. This could cause the government to adopt a more reckless fiscal policy, raising concern for businesses and investors in that economy.

Wealth Stores: Why the price of gold rises in a financial crises is because it is a safe holding which will always keep it’s value. With fiat money, a country no longer needs to hold gold in it’s vaults, often holding less. This can spell trouble if a crises causes an evaporation of paper wealth, at least if it has a commodity stored, it has a safe store of wealth.

The US left the Gold Standard in 1971, since then, national debt has escalated below. Moral Hazard of government perhaps?

The Benefits of Fiat Money

Deflation: If the money supply is backed with a finite commodity, there is a limit to the money supply growth. Economic growth can easily exceed the commodity, causing fixed money to chase more goods, causing problems.

Floating Exchange Rate: Commoditised money for several economies means their exchange rates are fixed together. With unbacked money, a country can devalue it’s currency in a downturn for stimulation.

Commodities Run: If we are to have an exodus of the commodity which backs our money, the money supply contracts and we have problems on the demand side. Milton Friedman attributes this as the cause of the great depression in the UK, when the holdings of gold and hence money contracted by 30%.

Monetary Accomodation: With a competent central bank, the money supply can be increased in line with total incomes to prevent a scarcity of money with economic growth. This is arguably easier than chasing the backed commodity to enable expansion.

Exchange Rates are fixed artifically in commoditised system, possibly causing distortions.

Independent Central Bank

With this, a fiat money system can work as the disadvantages of moral hazard and hyperinflation, that the government can simply print away it’s debt, are lessened.

The Bank of England was made independent in 1997 for this reason.

One Response to Fiat and Commodity Backed Money

  1. Pingback: Thinktank « Zahablog's Economic Page

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