Commodity Money: A Primer

Much has been said recently about commodity money.  Unfortunately, a number of the things that have been said have been misleading or misinformed.  Similarly, it is fairly strange that so many people assert the benefits OR the costs of a commodity standard as evidence for or against.  A careful analysis would suggest a comparison of benefits AND costs.  Given that the commodity money research cupboard has laid bare – for the most part – for some time, it might be useful to dust off the theory and address it in a meaningful fashion.

In order to discuss the gold standard, I will address the specific case of a pure gold standard.  Under this scenario, it is true that either gold coins circulate as money or that bank notes are backed 100 percent by gold.  If we neglect the costs associated with coining, deterioration, and debasement, these are essentially equivalent from a macroeconomic perspective.  Once this framework is discussed I will proceed to a discussion of a fractional reserve gold standard (perhaps in a subsequent post).

Suppose that resources can be used to produce consumer goods and gold.  For a given amount of resources, R_fixed, we can write a production possibilities frontier:

R_fixed = R(C, G)

Where C is consumer goods and G is gold.  The marginal productivities can be of producing consumer goods and gold are, respectively, R_c > 0 and R_g > 0.

Resource owners earn income:

Y = (P_c/P_g) C + G

Where Y is income and P­_c and P_g are the prices of consumer goods and gold, respectively.

Equilibrium necessarily requires that

R_c/P_c = R_g/P_g

Or

R_c/R_g = P_c/P_g

This implies that the price of consumer goods in terms of gold is equal to the marginal opportunity cost (marginal rate of transformation).  Price changes in either industry would lead to resources shifting from one industry to another.

Under a gold standard, the price of gold is fixed.  In addition, we will assume that there is free coinage provided that the individual pays the resource cost.  With the price of gold fixed, there is a corresponding price level for consumer goods.  This highlights the main benefit of a gold standard.  With the price of gold fixed, the purchasing power of gold is fixed.  Holding everything else constant, this implies that the purchasing power of money in terms of consumer goods is fixed as well.  In other words, absence changes, the price level for consumer goods is constant.

Given this basic framework, we can summarize the mechanisms of the gold standard.

First, consider the case of a growing economy in which all industries are growing at the same rate as the overall economy.  In this case, there would be no change in the ratio of productivities.  Equilibrium implies that the ratio of prices would remain unchanged as well.  Since the price of gold is fixed, this means that the price level would remain constant.

Second, suppose that there is technological progress in gold mining, the discovery of a new mine, or that the gold mining industry is growing at a faster rate than that of consumer goods.  If we imagine a production possibilities frontier with gold on the x-axis and consumer goods on the y-axis, this implies that the production possibilities frontier gets flatter.  This implies that R_c/R_g rises as the opportunity cost of producing gold relative to consumer goods declines.  This necessarily requires that P_c/P_g rises as well.  Since the price of gold is fixed, this means that consumer prices will rise.

Third, it follows that if the rate of technological progress in consumer goods outpaces that of gold mining or if there is simply a lack of gold discoveries to keep the pace of gold mining in line with the rate of growth in consumer goods, the opposite change would occur.  In this case the opportunity cost of producing consumer goods would fall relative to that of producing gold.  This implies that P_c/P_g would fall.  With the price of gold fixed, consumer prices decline.

Each of these three examples described above concerns a change in flows.  It is possible, however, that a change in stocks might also have influence on the gold standard.  In order to discuss the role of stocks in this analysis we need to extend the framework as follows.  First, define the quantity of gold as the sum of monetary and non-monetary gold:

G = (M/P_g) + G_nm

Where G is gold, M is the quantity of money, and G_nm is the quantity of non-monetary gold.

In addition, monetary equilibrium is defined as when the supply of monetary gold (M/P_g) is equal to the demand for monetary gold:

M/P_g = L[Y, (P_c/P_g)]

Now, suppose there is an increase in the demand for money.  The effects can be considered in the context of stock/flow equilibrium.  An increase in the demand for money is an increase in the demand for the stock of monetary gold.  The increase must be offset by a reduction in the demand for non-monetary gold, consumer goods, or a combination of both.  If the increase in money demand corresponds with a reduction in the demand for non-monetary gold, there is no further adjustment necessary.  The individual essentially just takes non-monetary gold to the mint.

If, however, the increase in the demand for gold corresponds with a reduction in the demand for consumer goods, the prices of these goods decline thereby increasing the purchasing power of gold.  It follows that an increase in the purchasing power gold encourages an increase in gold production.  However, since gold production is (usually) a small proportion of the existing stock of gold it takes an extended period of time for the adjustment to take place.

This adjustment likely results in reduced total output and lower prices, which is to some extent why deflation has been considered a poor outcome.  It is important to note, however, that in the first three examples we were concerned with flows rather than stocks.  In the case of flows, the fact that gold production is a fraction of the total stock of gold makes the adjustment process smoother.  Thus, when there is an increase in productivity in the consumer goods industry relative to the gold industry, the prices of consumer goods fall and deflation is associated with economic growth rather than economic contraction.

Finally, the last possible change to consider is a change in the price of gold.  As the model has been written, an increase in the price of gold would not affect the real side of the economy and therefore would only result in a corresponding increase in the price level of consumer goods.  In reality, however, the increase in the price of gold would result in a relative price change making consumer goods cheaper, which would increase the demand and production in consumer goods.  This would therefore entail temporary real effects that would ultimately result in a higher price level for consumer goods.

This discussion of commodity money, while somewhat long-winded, should highlight several important concepts.  First, it should be clear that the primary advantage of commodity money is that by setting the price of gold (or any such asset), the price level remains constant – absent any changes.  If gold production and consumer goods production grow at the same average rate over a period of time, the average price level will remain unchanged.  Second, the demand for money is important because if changes in the demand for money correspond with changes in the demand for consumer goods, these changes produce changes in the price level of consumer goods.  Since the gold mining is small relative to the stock of gold, this implies a long adjustment process.  Finally, changes in relative productivity across industries induce changes in the flow of consumer goods and the flow of gold.  These similarly entail an adjustment process, but that process is mitigated to some extent by the fact that the flow of newly mined gold is a fraction of the total stock.

A careful discussion of commodity money would require consideration of the costs and benefits.  Since much of the framework that I described above was based on that found in Niehans’s The Theory of Money, I would conclude the post with a quote from that text (p. 140):

“Commodity money does not exist today.  It is also not ideal in the sense that it is relatively easy to imagine non-commodity systems that are intellectually more satisfying than commodity money.  In fact, a non-commodity system, since it gives monetary policy more freedom, can if it is ideally managed, always do at least as well as any commodity money system and probably better.  Commodity money has therefore been denounced as a ‘barbaric relic’ from less enlightened stages of human society.  Yet, from a practical point of view, commodity money is the only type of money that, at the present time, can be said to have passed the test of history in market economies.”