steezysteezeCan somebody please explain to me why it's important for money to be backed by a physical commodity?
By pegging a currency to a physical commodity it prevents unwarranted inflation assuming that commodity is scarce.
Take the gold standard for example:
Gold has historically been an important and desired monetary unit. It has both physical and economic characteristics that make it both viable and desirable to be used as physical currency and high-powered money, or monetary base money. Its unique physical characteristics confer it with beneficial attributes that have made it historically desirable. It is extremely durable, very easy to recognize and store as well as being very portable. Importantly as well, it is impossible to counterfeit and is easy to measure, weigh and value consistently. Additionally, its scarcity as a resource makes it unlikely to fluctuate in its value as a result of massive changes in new supply.
The gold standard is a fixed exchange rate system that uses physical gold as an anchor for national currencies. The aforementioned physical characteristics and its economic benefits made it attractive to governments as a unit of exchange and store of value. It has a high cost of production, which makes its supply very difficult to manipulate over the short-run, promoting its use as a currency anchor. The use of the gold standard over the long-run is apparent in its price stability, making it a valuable asset to national governments.
The classical model of the gold standard was the preeminent model prior to WWI. There were rules to this standard, and their enforcement was necessary to maintain a proper trade balance and promote capital flows between markets. The rules were as follows:
1. Fix a gold price and convert gold freely between domestic money and gold at that price.
2. Lack of export restrictions on private citizens of gold or capital
3. Backing of national banknotes and coinage with gold reserves and condition long-run money growth on gold reserves.
4. To have the central bank extend liquidity at higher interest rate in cases of short-run liquidity crises resulting from gold outflows.
5. If Rule 1 is temporarily suspended, to restore convertibility at the soonest feasible point in time at the old parity.
6. Allow the common worldwide price to be determined endogenously by global supply and demand of gold
If governments and their central banks were to follow these rules, the natural consequence would be endogenous control over prices that facilitate capital flows. Subsequently, trade would become dependent on the relative price of gold and domestic and foreign income. If domestic price levels of a country were to rise relative to international price levels, then imports would increase. As a result, the increases of imports would then cause an outflow of gold in a process called price-specie flow which would return prices to their previous levels.
Under this classical model, central banks were allowed to use tools of monetary adjustment to change gold flows. Central banks could move money supply in anticipation of gold flows rather than allowing it to happen passively. However, these central banks were expected not to pursue counter-cyclical monetary policy to manipulate domestic interest rates and devalue their currency.
