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Chapter 25: Problem 2

What is the difference between commodity money and fiat money?

Short Answer

Expert verified
Commodity money has inherent value (the material it is made from has value), whereas fiat money value is set by legal decree and not backed by a physical commodity. Fiat money has value because the government maintains that value, or because two parties involved in an exchange agree on its value.

Step by step solution

01

Define Commodity Money

Commodity money is a type of good that functions as currency. In this system, the objects that act as money have intrinsic value or uses apart from their use as money. Gold coins, for example, are commodity money. They're made out of a valuable, precious metal that people want for reasons other than just their use as a form of currency.
02

Define Fiat Money

Fiat money is a currency that a government has declared to be legal tender, but it is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material from which the money is made. The most common examples of fiat money are the currency notes and coins that we use in our everyday transactions.
03

Explain the Difference

The fundamental difference between commodity money and fiat money lies in their inherent value. Commodity money has its own intrinsic value independent of its use as money, while fiat money gets its value by a legal decree or law, not from the material from which it’s made. Fiat money's value is also based on the trust that the government will maintain that value, or that parties engaging in its exchange will find it valuable.

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Most popular questions from this chapter

In November 2016 , the Indian government decided to withdraw paper currency that made up more than 86 percent of the value of all rupee bills in circulation. An article in the Wall Street Journal published shortly after that decision described a small merchant in India as having "traded one customer a kilogram of potatoes, cauliflower and tomatoes for half a liter of honey. That was a good deal, he says. In normal times, the honey would be 120 rupees in the market (around \(\$ 1.80\) ) and the vegetables 70 rupees." Is this merchant's ability to arrange a barter deal with a customer an indication that the Indian economy doesn't actually require money to function efficiently? Briefly explain.

If velocity does not change when the money supply of a country increases, will nominal GDP definitely increase? Will real GDP definitely increase? Briefly explain.

During the years from 2010 to 2016 , the average annual growth rate of \(\mathrm{M} 1\) was 10.3 percent, while the inflation rate as measured by the GDP deflator averaged 1.6 percent. Are these values consistent with the quantity equation? If you would need additional information to answer, state what the information is. Are the values consistent with the quantity theory of money? Briefly explain.

Suppose that Congress passes a new law that requires all firms to accept paper currency in exchange for whatever they are selling. Briefly discuss who would gain and who would lose from this legislation.

Suppose you withdraw \(\$ 1,000\) from a money market mutual fund and deposit the funds in your bank checking account. Briefly explain how this action will affect \(\mathrm{M} 1\) and \(\mathrm{M} 2 .\)
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