Fiat Money vs. Commodity Money: Which Currency Faces Higher Inflation Risks?

Adam Hayes, Ph.D., CFA, is a seasoned financial expert with over 15 years of experience on Wall Street as a derivatives trader. Holding advanced degrees in economics and sociology, Adam combines deep knowledge in economics and behavioral finance. He currently teaches economic sociology and finance at Hebrew University in Jerusalem.

Fiat money is currency that derives its value from the trust and confidence people place in the issuing government, unlike commodity money, which is backed by tangible assets like gold or silver. Since fiat currency can be produced without strict limits, many economists argue it is more vulnerable to inflation.

Unlike commodity money, which possesses intrinsic value due to its material composition, fiat money's value depends entirely on public trust. A loss of confidence in the issuing authority can render fiat currency worthless. However, commodity money is not immune to inflation or deflation either, as fluctuations in the availability of the underlying commodity can affect its value. Both forms of money can experience volatility, but fiat money is generally considered more prone to inflation due to its unlimited supply potential.

Key Insights

• Inflation reflects the rate at which average prices rise across an economy over time.
• According to monetarist theory, inflation reduces the purchasing power of currency units.
• Commodity money holds intrinsic value tied to precious metals, but increases in metal supply or debasement can trigger inflation.
• Fiat money’s value rests solely on government backing and tax authority, making it susceptible to inflation when supply increases unchecked.

Commodity Money and Inflation Dynamics

Commodity money carries inherent value but is subject to price swings linked to commodity market conditions. For example, a sudden large silver discovery can cause silver-backed currency to lose value, leading to inflation.

Historically, the influx of gold and silver from the New World in the 16th and 17th centuries caused severe inflation in Spain due to the surge in precious metals.

Inflation can also arise through debasement, where coins contain less precious metal than their face value suggests. Governments might alloy coins with cheaper metals or individuals might clip or file coins, reducing their precious metal content and thus their intrinsic value.

Historical Note

The U.S. officially ended the gold standard in 1933, but the dollar remained linked to gold until President Nixon completely severed the connection in 1971.

Fiat Currency and Inflation Risks

Governments issue fiat currency for convenience and to avoid the price instability linked to commodity money. Fiat currency is not backed by physical assets but derives value from supply-demand dynamics and government stability.

Modern major currencies, including the U.S. dollar and euro, are fiat money.

Initially, many fiat currencies were commodity-backed, allowing holders to exchange currency for a set amount of precious metal. Over time, this link was removed, and currency value became primarily based on public confidence.

Since 1933, U.S. citizens could no longer exchange dollars for gold, and by 1971, the U.S. stopped exchanging gold for foreign governments. Today, most governments believe commodity-backed money is less practical.

Without physical reserves backing fiat money, it risks losing value through inflation or hyperinflation if public trust erodes. Unlike commodity money, which retains intrinsic worth due to demand for metals in various industries, fiat money’s value is more fragile.

Real-World Inflation Example

Zimbabwe’s early 2000s hyperinflation illustrates fiat money’s risks. The central bank’s excessive money printing led to inflation rates reaching billions of percent, forcing citizens to carry enormous amounts of currency for basic goods. At the peak, one U.S. dollar equaled approximately 8.31 billion Zimbabwean dollars.

Does the Federal Reserve Print Money?

The Federal Reserve doesn’t physically print money but can expand the money supply by purchasing securities and adjusting interest rates, which influence lending and inflation.

Drawbacks of Commodity Money

Commodity money’s value can fluctuate sharply with changes in the underlying asset’s market. For instance, a sudden increase in gold supply can reduce a gold-backed currency’s purchasing power.

Current Status of the Gold Standard

No country uses a pure gold standard today. Switzerland was the last to maintain gold backing until 1999 and rejected a partial gold peg in 2014.

Conclusion

Both fiat and commodity money face risks affecting their purchasing power. Fiat currency is more vulnerable to inflation due to its unlimited supply potential, while commodity money can experience inflation or deflation tied to commodity market shifts. Understanding these dynamics is essential for grasping currency value fluctuations.

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