CREDIT MONEY

Credit money is any claim against a physical or legal person that can be used for the purchase of goods and services. Credit money differs from commodity and fiat money in two ways: It is not payable on demand (although in the case of fiat money, "demand payment" is a purely symbolic act since all that can be demanded is other types of fiat currency) and there is some element of risk that the real value upon fulfillment of the claim will not be equal to real value expected at the time of purchase.

This risk comes about in two ways and affects both buyer and seller.

First it is a claim and the claimant may default (not pay). High levels of default have destructive supply side effects. If manufacturers and service providers do not receive payment for the goods they produce, they will not have the resources to buy the labor and materials needed to produce new goods and services. This reduces supply, increases prices and raises unemployment, possibly triggering a period of stagflation. In extreme cases, widespread defaults can cause a lack of confidence in lending institutions and lead to economic depression. For example, abuse of credit arrangements is considered one of the significant causes of the Great Depression of the 1930s.

The second source of risk is time. Credit money is a promise of future payment. If the interest rate on the claim fails to compensate for the combined impact of the inflation (or deflation) rate and the time value of money, the seller will receive less real value than anticipated. If the interest rate on the claim overcompensates, the buyer will pay more than expected.

Over the last two centuries, credit money has steadily risen as the main source of money creation, progressively replacing first commodity and then representative money. In many cases credit money has been converted to fiat money (see below), as governments have backed certain private credit instruments (first banknotes from central banks, then later certain types of deposits to banks), thus converting central banknotes to legal tender, and other types of notes (deposit certificates of less than a certain value) to a status not very different from fiat money, since they are backed by the power of the central government to redeem eventually with tax collection.

A particular problem with credit money is that its supply moves in line with credit/business cycles (colloquially: "booms" and "busts"). When lenders are optimistic (notably when the debt level is low), they increase their lending activity, thus creating new money. This may also trigger inflation and bull markets. When creditors are pessimistic (for instance, when debt level is perceived as too high, or unwise lending activity in the past has resulted in situations where defaults are expected to follow), then creditors reduce their lending activity and money becomes "tight" or "illiquid." Bankruptcies and market recessions (so-called bear markets) then follow.

REPRESENTATIVE MONEY

Representative money refers to money that consists of token coins, other physical tokens such as certificates, and even non-physical "digital certificates" (authenticated digital transactions) that can be reliably exchanged for a fixed quantity of a commodity such as gold, silver or potentially water, oil or food. Representative money thus stands in direct and fixed relation to the commodity which backs it. This is to be distinguished from commodity money which is actually composed of a real and intrically valuable physical commodity.

COMMODITY MONEY

Commodity money is any money that is both used as a general purpose medium of exchange and as a tradable commodity in its own right. An example is coins made of precious metal.

Commodity-based currencies are often viewed as more stable, but this is not always the case. The value of a commodity-based currency as a medium of exchange depends on its supply relative to other goods and services available in the economy. Historically, gold, silver and other metals commonly used in commodity-based monetary systems have been subject to regular and sometimes extraordinary fluctuations in purchasing power. This not only damages its stability as a medium of exchange; it also reduces its effectiveness as a store of value. In the 1500s and 1600s huge quantities of gold and even larger amounts of silver were discovered in the New World and brought back to Europe for conversion into coin. As a result, the purchasing power of those coins fell by 60% to 80%, i.e. the prices of goods rose, because the supply of goods did not keep pace with the increased supply of money. In addition, the relative value of silver to gold shifted dramatically downward. Such discoveries of huge sources of gold or silver are a thing of the past, and lend to their supply stability. More recently, from 1980 to 2001, gold was a particularly poor store of value, as gold prices dropped from a high of $850/oz. ($27.30 /g) to a low of $255/oz. ($8.20 /g). It should be noted that gold was not a currency at this time, and was fluctuating due to its status as a final store of value — that is, the price never goes to zero as fiat currencies inevitably do. The advantage of gold and silver, however, lies in the fact that, unlike fiat paper currency, the supply cannot be increased arbitrarily by a central bank.

It is also possible for the trading value of a commodity money to be greater than its value as a medium of exchange when governments attempt to fix exchange rates between different commodity monies. When this happens people will often start melting down coins and reselling the metal used to make them. This has happened periodically in the United States, eventually causing it to move away from pure silver nickels and pure copper pennies.Shipping coins from one jurisdiction to another so that they could be reminted was sometimes a lucrative trade before the advent of trusted paper money.

Commodity money's ability to function as a store of value is also limited by its very nature. Copper and tin risk rust and corrosion. Gold and silver are soft metals that can lose weight through scratches and abrasions, but this is nothing by comparison to fiat currencies, where billions of dollars can be injected ("printed") into the market within moments.

Stability aside, commodity-based currencies may have a tendency to restrain growth in a very active economy. For example, in order to maintain the price level, the supply of money in an any economy must be equal or greater than the volume of goods and services produced. If commodities are used as money, then the total production can easily outstrip the supply of those commodities, which leads to price deflation. The lower prices of goods would signal to their producers to reduce the supply of goods, hence restoring the price level. As such, production within commodity-based economies tends to be limited by the supply of the commodity currency.

This problem is compounded by the fact that money also serves as a store of value. This encourages hoarding (in other circumstances known as "saving") and takes the commodity money out of circulation, reducing the supply. The supply of circulating commodity currency is further reduced by the fact that commodity moneys also have competing non-monetary uses. For example, gold and silver are used in jewellery, and nickel and copper have important industrial uses.

Commodity currencies may limit the geographic extent of the trading market. To make large purchases either a large volume or a high weight or both of the commodity must be transported to the seller. The cost of transportation of the currency raises the transaction cost and makes long distance sales less attractive.