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Commodity money is any form of currency that can serve a purpose other than as money. The best known examples are precious metals such as gold and silver, though other items such as cigarettes or even peppercorns have been or are used for this purpose. It offers benefits like more flexibility for money holders, the possibility of getting rich quick, and a built-in brake on inflation in the economy. It's important to note that modern economists argue that these advantages have limitations and are outweighed by drawbacks, which is why this type of money is almost never used as currency in developed economies.
There are four main types of money. The most common type is fiat money, a form of currency — usually coins or bank notes — that derives its value simply from the fact that the government has declared it as legal tender, meaning it must be accepted for settlement of debts. Representative money is where a token such as a note or certificate derives its value from a government promise that it can be exchanged from a commodity such as hold. Commercial bank money is the money that exists within the banking system. As banks usually borrow and lend much more money than they have in cash, commercial bank money is considered non-physical.
The main advantage of commodity money is simply that it serves an additional purpose. For example, gold can be turned into jewelry, while cigarettes can be smoked. This gives the holder added options; he can either use or spend the money. This can also be seen as a disadvantage. If cigarettes become an informal currency in prison, for example, smoking a cigarette can become a costly activity.
Another advantage of this type of money for some people is that it may be possible to acquire money that wasn't previously in circulation. For example, if gold is used as commodity money and somebody discovers more of this metal, he or she may be able to get more value from its role as money than from its role as a base for jewelry. Of course, this can be a major disadvantage for the economy as a whole, as it will counteract the way money is used in a market economy to ultimately decide how assets are used and allocated.
In theory at least, commodity money has a built-in supply limitation; without a major discovery, the amount of silver, for example, will remain constant. This contrasts to fiat money, where a government can create more money either through technical measures such as quantitative easing, or simply through printing notes. This means that there is a risk of government actions causing inflation and the devaluation of existing money, which isn't so likely with gold or other commodities.
A common misconception about having a commodity money system is that it results in a constant value for currency. Actually, though, the value of product cash is no more continuous than the value of the product that denominates it.
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