Crypto ELI8: Commodity Money vs. Fiat Money

The Crypto ELI8, or Explain Like I’m Eight, series is for anyone who wants to learn about the exciting world of cryptocurrency. Each post is organized around a specific term, concept, question, or other topic related to crypto.

For more on what the series is and a full list of posts check out this series guide.

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Money comes in many forms. Money is only valuable because people agree it is. What’s thought of as money in one place might not be valuable in another place. In this post, we’ll look at two of the most common forms of money — commodity money and fiat money. Although commodity money and fiat money have a lot in common, they differ greatly when it comes to where they derive their value.

Imagine this…

This year for Mother’s Day, you and brother each want to give your mom an extra special gift. Instead of buying a gift from the store, you decide you want to do extra chores for her. Even though you two have the same idea for what you want to give, each of you has a different idea for how to do it.

You know that Kit-Kat bars are your mom’s favorite candy. She loves them so much that she even asks you to hide them sometimes when they’re in the house because, if she knows where they are, she can eat too many and get a tummy ache. So you come up with an idea.

You buy a big bag with 40 fun-size Kit-Kats. You give 10 to your mom and hide the rest in your bedroom. (Luckily you don’t like Kit-Kats so you’re not tempted to eat them yourself.) You also give her 30 of your old baseball cards. Each baseball card represents 1 Kit-Kat bar.

You tell your mom that she can give you Kit-Kats or baseball cards at any time and in exchange you’ll do extra chores. Or, if she doesn’t have any Kit-Kats left but has a sweet tooth, she can give you a baseball card in exchange for a Kit-Kat.

Your brother decides to do something a little different. He gives her a coupon book. Each coupon represents a specific chore. The coupons say things like: 1 clean the bathroom, take out the trash for a week, 1 wash the windows. Whenever your mom “redeems” the coupon, your brother promises to do that chore.

He also gives her 10 Mom Bucks. This is paper money he made that your mom. Each Mom Buck is equivalent to one chore. This way, she can turn in a Mom Buck in exchange for chores that aren’t in the coupon book.

Your mom loves both your gifts! She says they’re the best Mother’s Day presents she’s ever got and can’t believe how smart her kids are!

So, what’s the difference between commodity money and fiat money?

Fiat money derives its value from government backing. Image credit: Christine Roy. Source: unsplash.com

A key difference between commodity money and fiat money has to do with where its value comes from. Commodities are things you can hold. Gold, silver, and wheat are examples of commodities. They are valuable even if they aren’t used as money. This is called intrinsic value.

Fiat, on the other hand, does not have intrinsic value. Its value comes from whoever made it. More specifically, governments create fiat money and, because they say it’s valuable, it is. The US dollar and Japanese yen are examples of fiat. Outside of the fact that a government says you can buy stuff with a dollar bill, the bill itself is not valuable.

In the Mother’s Day example, whose gift do you think represented commodity money and whose represented fiat money?

Your gift was like commodity money while your brother’s was like fiat money. Even if your mom couldn’t trade in Kit-Kats for chores, the candy has intrinsic value because it tastes good. Your brother’s gift, on the other hand, is like fiat money because coupons and Mom Bucks are valuable only because your brother says they are.

You can think about your brother like a government who printed money. He created value out of this air and represented this value with coupons and Mom Bucks. These coupons and Mom Bucks were forms of what governments call legal tender. That means the government says something is valuable and can be used as a form of payment.

You might be thinking, well what about the old baseball cards you used to represent Kit-Kats? This is called representative money. Like fiat money, representative money does not have intrinsic value. Unlike fiat, though, representative money represents something of value and can be exchanged for whatever it represents.

So, what is cryptocurrency?

Cryptocurrency is a form of digital money. It’s not a commodity because it doesn’t have intrinsic value but it’s also not fiat because governments don’t make it (with the exception of central bank digital currency). You can’t hold it, like fiat, but it’s (often) limited in supply like a commodity.

Today most of the world uses fiat money. Cryptocurrencies emerged largely as an alternative to fiat. Cryptocurrency systems try to fix some of the issues commonly associated with fiat, such as inflation.

Cryptocurrency is still relatively young compared to fiat and especially young compared to commodities. No one knows exactly what will happen — if most of the world will start using cryptocurrency instead of fiat, if it will become a long-term store of value like gold — but there’s no denying its importance today.

Summary

A main difference between commodity money and fiat money is where they get their value. Commodities, such as gold, silver, and wheat, have intrinsic value. While fiat, such as the US dollar and Japanese yen, derives its value from the word of the governments who created it. Unlike commodities, which are generally limited in supply, fiat can be printed by governments. Today, global economies operate within a fiat money system. Cryptocurrencies emerged, in part, as an alternative to fiat.

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