A Monetary System is defined as a set of policies, frameworks, and institutions by which the government creates money in an economy. Such institutions include the mint, the central bank, treasury and other financial institutions. There are three common types of monetary systems – commodity money, commodity-based money and fiat money.
Currently, fiat money is the most common type of monetary system in the world. For example, the US Dollar is a fiat money.
The Three Types of Monetary Systems
1. Commodity Money
This is made up of precious metals or other commodities that have intrinsic value. In order words, the monetary system uses the commodity physically in terms of currency. This form of money retains its value even if its melted down. For example, gold and silver coins have been commonly used throughout history as a form of money.
2. Commodity-based Money
This draws its value from a commodity but doesn’t involve handling the commodity on a regular basis. The notes don’t have physical value but can be exchanged for the commodity it is backed by. For example, the US Dollar used to draw its value on gold. This was known as the Gold Standard.
3. Fiat Money
In this system the currency, which by government decree is legal tender, i.e. that the government guarantees the value of the currency.
Today, most monetary systems are fiat money because people use notes or bank balances to make purchases. Fiat money is made up of paper currency or base metal coin. However, today, most of fiat money is in the form of bank balances and records of credit or debit card purchases.
Uses of Money
Money is used as a means of payment or a medium of exchange and therefore eliminates the coincidence of needs problem that is created by a barter system. The coincidence of needs requires that two parties want what the other person is willing to trade, and thus makes it difficult to trade.
It is also a standard unit of measurement that can be used to price things and to compare value. For example, a book costs $150, a meal costs $5 and a long distance call costs $0.10/min. To compare their value, we can say 1 book = 30 meals = 1500 minutes on a long distance call.
Money can be used to store value, and thus it becomes an asset itself. However, money may not be a good store of value since it loses value over time due to inflation.