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money will encourage people to use the item more in its commodity use. For example, if gold serves as money, and its value drops, people will increase their use of gold for jewelry, tableware, and artistic purposes. Their actions will reflect the law of demand: whenever a commodity becomes cheaper, people use more of it. Thus if there is a sudden influx of gold into a country that uses it as money, part of the influx will be diverted to its commodity use, and the effects on the amount of money, and hence on the price level, will be lessened. On the other hand, a sudden decline will also be cushioned, because as the commodity grows more valuable, people will transfer it from its commodity use into a monetary use. If the amount of gold declines and it rises in value, there is an incentive to melt down jewelry, tableware, and artistic objects and use the gold as money. Hence a doubling of gold may not double the amount of money, and cutting the amount of gold by one half may not cut money by one half Another reason for price stability with a commodity money exists when that commodity is used by many other nations. When the price level in any one nation changes, the commodity will flow across borders to where it is most valuable( Robert Schenk, PhD, University of WisconsinMadison, 1977 ). Savings
Commodity monetary system can keep the value of money from changing. However, economists tend to view deflation (appreciation of currency value) as being even more harmful to an economy than inflation (depreciation of currency value). This is because deflation gives incentive for people to save their money, while inflation gives incentive for people to save or invest their money. For this reason, governments on a fiat system tend to target a trend of general inflation by continually printing extra money. Commodity systems often result in deflation because the supply of the commodity that backs the currency tends to grow more slowly than the economy as a whole. While such deflation can be harmful to economies in other ways, it is beneficial to those who save their money, as they can see their wealth increase with no effort or risk on their part. Nonpolitical Value
When a government uses a fiat currency, the value of that currency comes from the amount in circulation and from the faith that people have in the government. However, if the government becomes unstable or falls, the value of that currency can evaporate. If that nation uses commodity money, even if the government becomes unstable or falls, the value of the currency remains. Disadvantages of Commodity Money When valuable resources are used as money, those resources cannot be used for consumption. Copper used to make pennies cannot be used to make electrical wire. The supply of money is determined by supply of the commodity. The money supply could fluctuate substantially. The discovery of new gold would mean that the supply of money would increase and the price level would rise. There is a lack of stability when a currency depends on being able to find and
produce a particular naturally occurring but naturally rare substance. When gold is being used as commodity money it can be a disadvantage since the government can't meaningfully increase the supply of gold over a short period of time, for example the Fed can be able to increase the supply of fiat money in 10 weeks by more than 100%, with gold this cannot be accomplished. Risk of Volatility
While commodity money typically has less volatility during turbulent economic developments, commodity money can still lose value. For example, both gold and oil are valuable commodities. However, the prices of both gold and oil undergo increases and decreases over time. Thus, the risk of volatility still exists with commodity money. Supply and demand can significantly affect the price of commodities. For example, after a hurricane the supply of oil may get disrupted, causing the price of oil to rise. Lack of Divisibility
Commodity money is typically not as divisible as traditional paper money. For example, you can divide dollars into quarters, nickels, dimes and pennies. However, you may have a difficult time dividing a bar of gold into small denominations needed to make everyday purchases.
Value
Another problem with commodity money is assessing the value of items purchased with the commodity money. In other words, how can you determine that you are, in fact, getting your money's worth for the purchased item? Measuring the exact amounts of value of commodity money is not easy, and therefore, it is difficult to manage your wealth using commodity money. In contrast, if you buy using paper money, you always know what you get for that paper money, even if the value changes over time.