Commodity money vs. Fiat money | Financial sector | AP Macroeconomics | Khan Academy

Let's take a look at a United States one dollar bill. What is it that gives this thing value? You can give it to people and get back, you know, food that you can eat or things that you can use and things of hard value. But what is it about this little piece of paper that makes it valuable? I guess it's not paper, is it? It's cotton, something like that, right?

But the question stands, right? Like, what makes this flimsy little thing that doesn't seem to have any use in its own right valuable? Well, one kind of interesting exercise is to step back in time a little bit and take a look at what the very, very first United States dollars looked like. So, I have here one of the very first that was printed, and let's zoom in on it and kind of read some of the words associated with it.

So if we zoom in, let's just say towards the very top here, notice that it says "silver certificate." Silver certificate up here at the top. So what does that mean? Well, if we zoom out a little bit it says it certifies that there has been deposited in the treasury of the United States of America, and then the sentence kind of continues in an awkward way below "one silver dollar payable to the bearer on demand."

So what that means, what this dollar originally represented, was the fact that you were going to be able to turn in this bill for a silver dollar. This piece of paper, in theory, could be turned in to the United States Treasury, which guaranteed that it had in its deposits a silver dollar—an actual piece of silver. And I'll show what one of those looked like in just a moment, that it would return to you for this bill.

So in a sense, what gave it value was this guarantee that you could turn it into silver if you wanted. So this way, you could trade this with other people as if it was a piece of silver. Because if you gave it to someone, that person now, being the bearer on demand, could then, in theory, turn this in and get a silver dollar as a result.

The reason for even having this paper money and printing these bills is that it was pretty inconvenient to always lug around actual pieces of silver and actual pieces of metal, and this would be especially true in the case of even higher amounts. So, for example, here we have a ten thousand dollar bill—something you don't really see too often.

And if we zoom in and kind of see the guarantees that are written on this guy, it's actually very similar, but instead this is in gold instead of silver. It says that ten thousand dollars in gold are payable to the bearer on demand, as authorized by law. So, kind of legally backing up the idea that this could be turned in for ten thousand dollars worth of gold.

So that way, people could actually treat this as if it was, you know, ten thousand dollars worth of gold without having to lug around that much money. So what is it that you actually got when you turned in, you know, for one silver dollar or something like that? What is it that was payable on demand?

Well, you have what's another form of money that you can use in commerce and kind of trade with people as a medium of exchange—officially United States money. But the difference is that the piece of money itself is the valuable metal; it actually is the silver. So in theory, if you didn't trust the United States government anymore, you could melt it down for just the pure silver, and maybe other countries still value that silver.

Similarly, there were gold coins like this that people would use. Like this right here is a gold coin worth two and a half dollars, so this is something where the value is held within it because presumably people value gold. And even if this didn't have a fancy, you know, United States symbol all stamped onto it, it would be something valuable because it's gold.

And this kind of money, you know, gold coins or these silver coins has a special kind of name—it's called commodity money. Let's see, commodity money. And basically what this means is that the thing that you're using for money, the thing you're trading around, has some value in its own right. Even if it wasn't money, it would still be something valuable.

This word here, commodity, basically means just anything valuable. It could not only be, you know, silver or gold, but things like food or furniture or livestock. These are commodities, and, you know, you could argue that silver and gold aren't valuable other than the fact that people just like using them for trading. I mean, they're kind of pretty and useful for jewelry, and there's some electronics that use them, but on the whole, the main reason that people value silver and gold is because they're used for trading—it's kind of because other people value them.

So it's a little bit weird that these are the quintessential examples of commodity money, when in fact, other commodities, you know, like wheat or oranges feel much more, you know, real, hard, valuable, something you can use in its own right than the pieces of metal. But nevertheless, these are commodities.

And the other form of money here, where you have something that you could in theory exchange to a bank and then the bank would return to you, you know, the actual silver that it represents, the commodity that it represents— in this case, silver—these are called commodity-backed money. Backed, because their value is being backed up by the value of whatever commodity they represent.

Another term that you might hear for them is representative money because they are representing another good—representative. In this case, silver or gold. But in the early days of money, like thousands of years ago, you would have representative money like the shekel, which represented a certain weight of barley.

So it doesn't just have to be silver or gold. Sometimes you have money that represents a different sort of commodity, so commodity-backed representative. This is the kind of old-style United States or other countries' money. A lot of people had commodity-backed money.

But in modern terms, it's common not to have either of those. You just have this bill that's not backed up by silver; you could not turn this in and get silver as a result. And this is termed fiat money. Fiat money. And this word fiat kind of means a decree or a declaration.

So it's like the United States government has declared that this is money, and just by declaring that it's money, presumably that gives its value. So it kind of feels much more hollow in comparison to, you know, commodity money or commodity-backed money. But there's a couple hard things backing this up. One of them, if we kind of zoom in on some of the words here, if you go, you see that it says this note is legal tender.

So here I'll write that down—this note is legal tender for all that's public and private. And I talked about the idea of legal tender in the last video and how that actually, you know, gives a little bit of clout to this being valuable, as long as you trust that the government will enforce its laws as it claims that it will.

But for the most part, what makes this stuff valuable is the fact that other people trust it, right? The reason that you value having a dollar bill is because you know you can give it to most people, and they are willing to trade you valuable things for it.

And at the end of the day, that's what was making, you know, silver dollars or these ten thousand dollar, you know, gold notes valuable because almost no one would actually trade it in for the silver, because why would you? It's just as good, and it's a little bit more convenient to just trade around the bill itself.

So once that's actually in the psychology of a society and once everyone kind of is used to the idea of trading around this paper representative money in order to be able to get things of value, it's not actually a huge leap to just have the paper that you're trading around, as long as everyone else trusts it. And it still serves those functions of money that I talked about in previous videos. It's a medium of exchange, and you can store this for value, right?

The paper is not going to degrade; it's something you can store, and it does give a unit of value, assigning a number to various goods out there. But it is just something that was declared; it's not an actual hard good.

And this is kind of an important distinction to recognize, is that fiat money really does mean it's just trusted. It's just taken on faith that people will find this valuable. But for that matter, that's also true of silver and gold, right? Like it's just taken on faith that if you melted down the silver, other people would find that valuable, and same goes for gold.

In fact, in some, you know, even though a lot of Western cultures valued gold a lot, there were other cultures that they might find, like in Asia, that didn't value gold in the same way and decide, "Why is everyone getting all up in a fuss about this fancy metal?"

So this idea of having money that we use basically because we trust that others will find it valuable isn't actually that absurd. And as long as it serves those same three basic functions of money, you can have a working society, you know, barring things like hyperinflation that makes it so that it no longer serves those functions of money.

See you next video.