Commodity Monetary Standard

Under a commodity monetary standard, a medium of exchange and unit of account is either a commodity or a claim to a commodity and the commodity is a good that would have value even if it were not used for money. Put differently, the commodity has an intrinsic value, in contrast to the paper money of an inconvertible paper standard that has value only by government fiat and is called fiat money for that reason.
In the purest form of commodity money, the commodity itself may change hands. History furnishes numerous examples of livestock, necessary staples, stones, shells, metals, etc., that have acted as a medium of exchange, a unit of account, a standard of deferred payment, and a store of value. The most famous and enduring commodity standard in history is the gold standard, but silver can boast of a history as a monetary standard that almost rivals the history of gold.
In more sophisticated commodity standards, paper claims to the commodity change hands in exchange, while the commodity itself is stored in warehouses or vaults. The gold standard of the nineteenth and early twentieth centuries perhaps offers the best example of a commodity standard in which paper claims to the commodity replace the commodity itself as the circulating medium. Less-developed countries of the world operated silver standards on the same principle, until inconvertible paper standards replaced all precious metal commodity standards in the twentieth century.
Although gold, and to a lesser extent silver, have been the most widely embraced commodities to act as the basis of the more sophisticated commodity standards, they do not stand alone. The colonists of Virginia stored tobacco in warehouses, and issued tobacco notes representing titles of ownership to the tobacco. The colonists quoted prices in tobacco, and tobacco notes exchanged hands instead tobacco itself. The colonists could freely convert tobacco notes into tobacco as needed. In the eighteenth and nineteenth centuries, Japan operated a similar system based upon rice. Rice notes circulated as money and even the value of gold and silver coins was expressed in terms of rice. In 1760 the Japanese government specifically forbade landowners from issuing rice notes in excess of the amount of rice they had stored, a common abuse in all commodity systems using paper claims to a commodity. Although in practice gold and silver have dominated commodity standards, in theory a whole range of commodities could serve the same purpose.
Under a commodity standard, the value of money is the price, determined by supply and demand, of a commodity that is costly to produce. A government agency sets the price at which it stands ready to buy and sell the commodity, and production of the commodity will expand to a level necessary to stabilize prices. If the official price of gold is $35 per ounce, as it was for a number of years under the United States gold standard, gold production expands to the point at which an ounce of gold costs just under $35 to produce. If gold is not profitable to produce at $35 per ounce, gold production contracts, reducing the world money supply and causing prices to fall. The average level of prices continues to fall, reducing the cost of producing gold, until gold becomes profitable to produce at $35 per ounce, at which point the world money supply (and prices) stabilize. If gold is highly profitable to produce at $35 per ounce, the gold production expands, adding to the world’s money stock, and prices rise, increasing the costs of producing gold relative to its selling price. Theoretically, gold production expands and contracts to keep price stable, creating a self-correcting mechanism for maintaining price stability. Although governments have more experience with the gold standard than other commodity standards, in theory the same principles work regardless of the commodity.
More complicated commodity standards can be devised using more than one commodity. The bimetallic standard that figured prominently in nineteenth-century monetary history was a commodity standard based on gold and silver. The inflation surge of the 1970s renewed interest in commodity standards among monetary economists. One idea that surfaced was a variable commodity standard based on a composite commodity. A composite commodity is a weighted combination of several commodities. Thus a variable commodity standard makes a currency convertible into a weighted basket of several commodities.