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Spotlight on Economics: The Monetary Role of Commodities

James Caton, assistant professor, NDSU Agribusiness and Applied Economics Department (NDSU photo) James Caton, assistant professor, NDSU Agribusiness and Applied Economics Department (NDSU photo)
Wheat Production and Price Data Wheat Production and Price Data
Markets regulate the quantity of money.

By James Caton, Assistant Professor

NDSU Agribusiness and Applied Economics Department

When I teach macroeconomics, I continually iterate to my students two facts:

  • Most depressions are aggregate demand driven. In other words, economic depression usually occurs due to oscillations in the quantity of money in circulation or oscillations in the demand for money.
  • Markets regulate the quantity of money supplied in light of demand for it. If consumers are willing to pay a higher price for money, firms will supply the market with more money. To use a technical term, the quantity of money is “endogenously,” or internally, regulated.

In a world where the central bank determines the quantity of base money in circulation, losing sight of fact No. 2 is easy to do. When gold or any other commodity serves as money, the quantity of the commodity in circulation is not strictly controlled by a central bank. It is controlled by profit-seeking producers of the commodity. Credit markets operate in a similar manner.

To say that the price of money has increased is to say that the prices of (nonmoney) goods have fallen, on average. The same amount of money buys more stuff. You can imagine that under a gold standard, for example, if an ounce of gold tends to purchase 30 percent more of any good, on average, gold producers will mine and mint more gold.

We see the same tendency in other commodity markets. When the price of wheat rose about a decade ago, global wheat production also increased. After the price fell, production levels remained relatively elevated as improvements in technology, triggered by the increase in price, lowered the marginal cost of production.

Because credit doubles as money, an expansion of the credit stock is an expansion of the money stock. Money that you deposit in your checking account, for example, is lent by a bank to borrowers, but the money on account is available for spending by the use of a check or a debit card.

We can compare the dynamics of production of base money to the dynamics of credit creation (lending). If investors expect a relative increase in return on investment, for example, they will be willing to borrow so long as their expected rate of return exceeds the interest rate.

Improvements in prospects for economic growth are associated with increases in the quantity of credit and, therefore, increases in the quantity of money. During economic booms, then, an increase in demand to invest money is associated with an increase in the credit stock. During a recession, banks tend to lend less, thus shrinking the money stock. This tends to occur just as investors are demanding more money to repay debts whose collateral has experienced a devaluation.

If the central bank controls the base money stock, investors must hope that the central bank responds by increasing the quantity of base money. Under a commodity standard absent a central bank, investors can be assured that the base money will begin to respond to this increase in demand for money during the course of the following year, much as wheat production responded to increases in price more than a decade ago.

Compare this with the Great Depression, where the central bank reduced the base money stock as the depression deepened, preventing the gold standard from generating relief to money markets. Economic depression, which is usually a period of falling asset prices, would be a boon to producers of the commodity that served as money. The path forward to this could occur one of two ways:

  • The central bank could adopt a basket of commodities to back the money in circulation. In 1943, F.A. Hayek suggested a system in which the central bank targets the price of a basket of commodities and regularly buys or sells the basket of commodities, depending on whether the price of the basket was, respectively, below or above the target price. This would avoid a monetary contraction like the one caused by central banks during the Great Depression.
  • Banks could be allowed to issue claims against commodities that are treated as money, much as checks written against dollars deposited in a checking account are treated as money. The second path is difficult due to taxation that occurs at the point of sale of commodities, as well as legal tender laws.

What is worth noting is that commodities futures markets presently operate in this fashion, although their response is limited, compared with an actual commodity standard, because commodities do not actually serve as base currency.

Before the downturn of the Dow, which started in October 2007, investors began to flock to commodities to hedge against market risk. Even after the start of the recession, which began in December 2007, commodities futures continued to attract investment until March 2008. These markets recovered much of their losses before the downtrend continued in June 2008. The price of gold continued to rise throughout the recession, as did the level of gold production.

In monetary theory, we refer to easily saleable instruments such as commodities futures as “near moneys.” They serve as a store of value. This value can be retrieved easily in the form of dollars if owners of these assets require actual dollars. Taxes on the sale of commodities impede this process. Their reduction or removal would allow futures markets to perform this stabilizing function with greater efficiency.

In closing, markets regulate the quantity of money. While this does not prevent economic downturns, it does limit their magnitude. During booms, lenders respond en masse to increases in demand for borrowing from investors. Under a monetary standard in which commodities serve as money, producers of the commodities that serve as money respond to an economic downturn by increasing production.

Even without a true commodity standard, we have observed this same phenomenon in commodities futures markets as investors increased the value of holdings of commodities futures contracts just as the major stock indices began their decline. The total value of investment in futures did not fall substantially for more than six months after the recession started, or nine months after the Dow Jones Industrial Average began its fall. These dynamics give reason to believe that commodity money can serve to stabilize economic volatility.

NDSU Agriculture Communication - May 17, 2018

Source:James Caton, 701-231-7337,
Editor:Ellen Crawford, 701-231-5391,
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