Question

What is the difference between commodity money and fiat money?

Short answer

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

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.

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.

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.

Key concepts

Intrinsic Value

Intrinsic value refers to the inherent worth of an object, deriving its value from what it essentially is, rather than what it is used for. Commodity money, such as gold or silver coins, has intrinsic value. These items are desirable and retain value even outside their role as currency. For instance, gold is not only valued as money but also for its aesthetic appeal and industrial applications.
Intrinsic value contrasts sharply with fiat money, which does not possess intrinsic value. The material of fiat money—like paper and base metal—is not particularly valuable. It is mainly the historical and ongoing demand for gold, for example, that contributes to its intrinsic value, which can act as a safeguard against economic downturns.

• Commodities such as gold and silver have value in multiple sectors, including jewelry and industry.
• Intrinsic value is independent of any governmental decree or health of the economy.

Legal Tender

Legal tender is a medium of payment recognized by a legal system to settle a public or private debt or meet a financial obligation. In most countries, the government designates certain types of money as legal tender, usually through legislation or regulatory authority. This means that individuals and businesses are legally obligated to accept it for payment
Fiat money is often designated as legal tender, ensuring its acceptance in financial transactions within a country's economy. Despite lacking intrinsic value, fiat money's status as legal tender gives it acceptability and utility in markets. This government endorsement distinguishes fiat money from other forms of currency.

• Legal tender must be accepted when offered for repayment of a debt.
• This government mandate ensures the use of fiat money for settling accounts and debts.

Government-Backed Currency

A government-backed currency is one that derives its value through the backing of a country's government. This support gives fiat money its perceived value, even though it does not have intrinsic worth like commodity money. Essentially, the government's ability to enforce acceptance of the currency and its power to regulate its supply contribute to its value.
The reliance on government-backed currency stems from trust in the government to maintain economic stability. When citizens and businesses have confidence that a government will keep inflation in check and ensure fiscal responsibility, the value of the government-backed currency strengthens.

• Fiat currencies derive value from government legislation and trust.
• The government monitors supply to manage inflation and support economic stability.