Updated Jan 14, 2023In economics, money is defined as a generally accepted medium of exchange for goods and services. Virtually anything can be considered money or a monetary aggregate as long as it performs what we call the three major functions of money (i.e., medium of exchange, store of value, unit of account). With this in mind, it is not surprising that there have been different types of money throughout history. To give you a brief overview, we are going to take a look at the four most relevant ones below: commodity money, fiat money, fiduciary money, and commercial bank money.
Commodity Money
Commodity money is the simplest and, most likely, the oldest type of currency. It builds on scarce natural resources that act as a medium of exchange, store of value, and unit of account. Commodity money is closely related to (and originates from) a barter system, where goods and services are directly exchanged for other goods and services (i.e., peer-to-peer). This type of money facilitates the exchange process because it acts as a generally accepted medium of exchange.
The important thing to note about this type of currency is that its value is defined by the intrinsic value of the commodity itself. In other words, the commodity itself becomes money, which makes it immune to inflation and ensures monetary stability. Examples of commodity money include gold and other precious metals, coins, beads, shells, spices, etc.
Fiat Money
Fiat money gets its value from a government order (i.e., fiat). That means the government declares this type of money to be legal tender, which requires all people and firms within the country to accept it as a means of payment. If they fail to follow this government-issued order, they may be fined or even put in prison. Unlike commodity money, fiat currency is not backed by any physical commodity but is issued by central banks. By definition, its intrinsic value is significantly lower than its face value. Hence, its value is derived from the relationship between supply and demand, trust in the government, and monetary policy of the central banks that are in charge of managing the money supply (i.e., inflation and monetary stability).
Most financial systems of modern economies are based on fiat currencies. Thus, examples of fiat money include most of the currencies (i.e., coins and paper money) around the world today.
Fiduciary Money
The value of a fiduciary currency depends on the confidence that it will be generally accepted as a medium of exchange. Unlike fiat currency, it is not declared legal tender by the government, which means people are not required by law to accept it as a means of payment. Instead, the issuer promises to exchange it back for a commodity or fiat currency if requested by the bearer. As long as people are confident that this promise will not be broken and the currency won’t lose its value due to high inflation, they can use this type of money just like regular fiat or commodity money.
Examples of fiduciary currency include cheques, banknotes, or drafts. Note that cryptocurrencies like Bitcoin or Ethereum can also be considered fiduciary (in most countries), although proponents suggest they constitute an entirely new type of money.
Commercial Bank Money
Commercial bank money (or just bank money) can be described as claims against financial institutions that can be used to purchase goods or services. It represents the portion of a currency that is made of debt generated by commercial banks from their bank deposits.
More specifically, commercial bank money is created through a banking system that we call fractional reserve banking. Fractional reserve banking describes a process where banks only hold a fraction of their deposits as bank reserves and use the rest to give out loans worth more than the value of the actual currency they hold as liquid assets. At this point, note that, in essence, commercial bank money is debt generated by the banking industry that can be exchanged for “real” money or to buy goods and services.
Summary
The four most relevant types of money are commodity money, fiat money, fiduciary money, and commercial bank money. Commodity money relies on intrinsically valuable commodities that act as a medium of exchange. Fiat money, on the other hand, gets its value from a government order. Meanwhile, the value of a fiduciary currency depends on the confidence that it will be generally accepted as a medium of exchange. And commercial bank money can be described as claims against financial institutions that can be used to purchase goods or services.
