A commodity money system is a type of monetary system in which a commodity such as gold or seashells is made the unit of value and physically used as money. The money retains its value because of its physical properties. In some cases, a government may stamp a metal coin with a face, value or mark that indicates its weight or asserts its purity, but the value remains the same even if the coin is melted down.
One step away from commodity money is "commodity-backed money", also known as "representative money". Many currencies have consisted of bank-issued notes which have no inherent physical value, but which may be exchanged for a precious metal, such as gold. This is known as the gold standard. A silver standard was widespread after the fall of the Byzantine Empire, and lasted until 1935, when it was abandoned by China and Hong Kong.
A 20th-century variation was bimetallism, also called the "double standard", under which both gold and silver were legal tender.[2]
The alternative to a commodity money system is fiat money which is defined by a central bank and government law as legal tender even if it has no intrinsic value. Originally fiat money was paper currency or base metal coinage, but in modern economies it mainly exists as data such as bank balances and records of credit or debit card purchases,[3] and the fraction that exists as notes and coins is relatively small.[4] Money is mostly created by banks when they loan to customers. Put simply, banks lending currency to customers, subject to each bank's regulatory limit, is the principal mode of new deposit creation.[5]
The central bank does not directly fix the amount of currency in circulation. Money creation is primarily accomploshed via lending by commercial banks. Borrowers who receive the money created by new lending in turn affect the stock of money, as paying off debts removes money circulating.[6]
Although commercial banks create circulating money via lending, they cannot do so freely without limit. Commercial banks are required to maintain an on-hand reserve of funds equaling a portion of their total deposits banks (Large banks in the United States, for example, have a 10% reserve requirement.[7]) Central banks set interest rates on funds available for commercial banks to borrow short-term from the central bank to meet their reserve requirement. This limits the amount of money the commercial banks are willing to lend, and thus create, as it affects the profitability of lending in a competitive market.[6]
^Velde, Francois R., "Following the Yellow Brick Road: How the United States Adopted the Gold Standard". Economic Perspectives, 4th Quarter, 2002. Available at SSRN: http://ssrn.com/abstract=377760 or doi:10.2139/ssrn.377760
^Brent Radcliffe. "Fiat Money". Investopedia. Retrieved 25 April 2015.
