'Commodity Money' is explained in detail and with examples in the Banking edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
There are several forms of money which have been used throughout history. The oldest and best proven form is known as commodity money. A form of money invented in the past century which has become the major competitor to this historical currency is called fiat money. A newer post-modern technologically advanced form of spending power is today’s electronic money. All three have their pros and cons, yet the arguments about commodities being safe and trusted keep them alive despite their critics colorfully referring to them as barbaric relics of ancient history.
Commodity money is that type of money that possesses intrinsic value on its own, independent of any governing body. This means the money itself contains its own worth. It is not merely a token or representative of financial value as with bank notes or numbers on a computer screen and in a ledger. The longest reigning and best loved form of commodity money remains gold and silver coins. Their history is legendary and stretches back five thousand years through times good, bad, and tragic.
Any type of commodity is able to fulfill the role of commodity money. As long as the money’s value springs from the material from which it is comprised and not some arbitrary decree of a ruler or government representative, it is in fact hard money. Numerous commodities in various times and places have been effectively utilized as this form of tired and true currency. Besides gold and silver, peoples, nations, and empires have employed salt, chocolate beans, copper, decorative belts, shells, cigarettes, and even large stones. Critics have argued that many of these forms of currency were prone to spoilage or gradual deterioration.
The overwhelming majority of cash forms with which people buy and sell nowadays lack any intrinsic value whatsoever. Banknotes are a case in point. They are fiat money. This is money that only contains any value because the government decrees it has the full faith and credit of the nation backing it. It works because members of society and businesses choose to accept it as their primary form of currency and means of exchanging goods and services.
It is interesting that commodity money does not have to be inherently useful to the owner to have value for exchange. Few people have practical uses for gold or silver coins. These coins have dramatically high value because goldsmiths and jewelers are able to utilize them to produce costly jewelry or collectible items of great worth and because of their inherent scarcity.
When societies choose to utilize such commodity money as metal coins for their official legal tender, it is up to the government in question to determine the fixed value of each coin in the currency lineup. The face value of these coins is the one that will be accepted rather than the value of the metal contained within each piece.
Coins are usually circulated at a face value that is greater than the costs of the underlying metal materials. There are some cases, as with runaway inflation, where coins can have greater metal value than face value. This is especially the case with coins made mostly or entirely from gold or silver. When this is a persistent problem, governments often attack the problem by taking that currency unit out of circulation.
Fiat money is the opposite of this commodity money. Fiat money only derives its value from legal claims and obligations of the law. It is truly like a purchase voucher which can be utilized to exchange for services and goods. This means that its purchasing power varies. Fiat money only has fixed value in settling debts. Originally it emerged as a means of convenience so that individuals could carry lighter paper certificates that the government guaranteed rather than having to ship and guard heavy gold and silver.
Over time, governments stealthily stopped exchanging this paper money for the gold and silver that originally backed it. Fiat money is now useless intrinsically and can not be redeemed for any commodity as it once could. The only reason it has any value at all is because the government says it will be valued for that purpose.