Key Takeaways
- Fiat money can be more prone to inflation since it can be printed without limits.
- Commodity money has intrinsic value but is affected by changes in supply or demand.
- Inflation reduces the purchasing power of a currency by increasing average prices.
- Hyperinflation, like in Zimbabwe, can make fiat currency nearly worthless.
- The U.S. completely untied the dollar from gold in 1971, moving to fiat currency.
Fiat money is currency backed by trust in the issuing government rather than intrinsic value, unlike commodity money that derives worth from physical assets such as gold or silver. Fiat systems can be more prone to inflation due to unlimited issuance, as seen in cases like Weimar Germany, while commodity money has experienced value shifts tied to changes in supply.
Understanding Inflation Risks With Commodity Money
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 centuries, 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 debasement of the currency. Debasement 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.
Important
Although the U.S. formally left the gold standard in 1933, the value of the dollar was still tied to gold until President Nixon fully abandoned the system in 1971.
How Fiat Currency is Impacted by 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 of hyperinflation. 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.
Real-World Inflation: The Zimbabwe Case Study
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 between 231 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.
Does the Federal Reserve Print Money?
The Federal Reserve does not technically print money, but it does have the ability to create new dollars, increasing the money supply. The Fed has two monetary tools that can affect inflation: First, it can buy Treasurys or other securities on the market, thereby injecting new dollars into the economy. Second, it determines the interest rate for for loans to commercial banks, which can raise or lower the interest rates throughout the economy.
What Are the Disadvantages of Commodity Money?
Commodity money, such as gold or silver, is vulnerable to volatility if the market for the underlying asset changes. For example, a currency backed by gold could see a sharp drop in purchasing power if the supply of gold suddenly increased due to new mining activity. Conversely, a change in demand for gold could see an increase or decrease in the value of the currency.
Do Any Countries Use the Gold Standard?
There is no country that use a pure gold standard to back the value of its currency. Switzerland was the last country to use a gold-backed currency, until it severed the connection between the Swiss franc and gold in 1999. A brief movement to reintroduce a partial peg was defeated by voters in 2014.
The Bottom Line
Both fiat money and commodity money are subject to volatility that can reduce their buying power. Fiat money, which is used by most modern economies, tends to be more prone to inflation when currency issuance is poorly controlled, while commodity money can experience inflation or deflation when supply or demand for the underlying asset shifts.
