People since the dawn of civilization created payment systems. Thus, money facilitates business transactions, and the payment system becomes the mechanism to settle transactions. First and oldest payment system is commodity money. Commodity money is government selects one commodity from society to become money, such as gold or silver. If society did not use gold or silver as money, then people still use the commodity for other purposes. People use gold in jewelry, teeth fillings, electrical wires, or the pins of a microprocessor. Commodity money could be anything.
For example, prisoners use cigarettes as money in U.S. prisons, while people accepted vodka and bullets as payment in remote parts of Russia during the 1990s. Commodity money could be full-bodied money. Its value as a good in non-money purposes equals its value as a medium of exchange. For instance, if the market value of one ounce of gold is $1,000, and the government made one-ounce gold coins, then the face value of the coin would equal $1,000. Thus, this coin represents full-bodied commodity money because the coin’s inherent value equals the coin’s market value.
Governments discovered a trick about commodity money. What would happen if a government made one-ounce gold coins with a face value equaled to $2,000 while the coin contained $1,000 of gold? Subsequently, a government had created $1,000 out of thin air! Government can create value by “printing money,” which we call seigniorage, and government could receive significant revenue by creating money. Government can debase its currency by relying on seigniorage. For example, the Roman government “printed money” by recalling its gold and silver coins.
This it re-minted more coins that contained less gold and silver by adding cheap metals. In the beginning of the ancient Roman Empire, coins were almost pure gold and silver, while, towards the end of the empire, Roman coins contained specks of gold and silver. For example, government can debase coins. If government issued one-ounce, gold coins for $1,000, and the coins were 98% pure gold, then government can print money by collecting the old coins and mint two new coins with a value of $1,000 that only contain 49% gold.
Then government fills the remaining 51% of the coin with cheap metals. Unfortunately, government could create extremely high inflation rates if it depends on seigniorage too much.