The best way to think about this idea and the severe problems with it are to think of prisoners using cigarettes as a medium of exchange. A medium of exchange is a valuable thing to have, and cigarettes are an appealing option. They’re light, small, largely non-perishable and have an “intrinsic” value to addicts. But once you have a whole cigarette-based economy, your problem is that this economy becomes subject to external shocks based on the supply and demand for cigarettes. If a bunch of heavy smokers suddenly get sent to your prison, demand for cigarettes skyrockets and the cigarette-denominated price of everything drops severely reducing real output as everyone enters a downward spiral of cigarette hoarding. Alternatively, the introduction of Nicorette into the prison might create declining demand for cigarettes and inflation.
In a fiat currency regime, if demand for dollars goes up you print more dollars. If inflation becomes problematic, you reduce the quantity of dollars. In a commodity-based regime, this doesn’t work. If China grows 8 percent per year and that drives up demand for the commodities to which your currency is pegged, then you get deflation. If entrepreneurs discover a much cheaper way to run mines, then you get inflation. Now if you happen to be operating in a low-trust environment like a prison these downsides may be small relative to the logistical hurdles involved in setting up a central bank. But if you already have a functioning central bank and a widely accepted currency, it’d be kind of crazy to give it up and revert to prison conditions.