What Are the Disadvantages of Commodity Money?

Commodity money is a type of currency tied to a particular commodity. Gold and silver are common commodities that you can use as commodity money. "The Ascent of Money: A Financial History of the World" explains that historically, uncertain economic times have increased the interest in commodity money because commodity money is not tied to the worth of a potentially volatile currency.

While commodity money typically has less volatility during turbulent economic developments, commodity money can still lose value. For example, both gold and oil are valuable commodities; however, the prices of both gold and oil undergo increases and decreases over time. Thus, the risk of volatility still exists with commodity money. Supply and demand can significantly affect the price of commodities. For example, after a hurricane, the supply of oil may get disrupted, causing the price of oil to rise.

Commodity money is typically not as divisible as traditional paper money. For example, you can divide dollars into quarters, nickels, dimes and pennies; however, you may have a difficult time dividing a bar of gold into small denominations needed to make everyday purchases.

Commodities also suffer from the bandwagon effect -- that the price of commodities may rise and fall with the whims of the general population. For example, if you have all your money in gold and the general population suddenly decides gold no longer has value, your commodity money based in gold will also no longer have value. Bank runs resulted in many individuals losing savings during the Great Depression when bank deposits were not federally guaranteed, and the same is also true of commodity money. When everyone leaves a commodity behind, the value drops, along with your investment.

Another problem with commodity money is assessing the value of items purchased with the commodity money. In other words, how can you determine that you are, in fact, getting your money's worth for the purchased item? Measuring the exact amounts of value of commodity money is not easy, and therefore, it is difficult to manage your wealth using commodity money. In contrast, if you buy using paper money, you always know what you get for that paper money, even if the value changes over time.