Fiat Money: Definition, How It Works, Pros & Cons

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That is, the cash has the value that a government attaches to it and does not represent a store of equal value, such as gold. Well into the 17th and 18th centuries, furs and other commodities that had recognized value could be used in lieu of cash in transactions. Precious metals like gold and silver were weighed and used as currency. The coins had actual value equal to the value that was stamped on them.

There is always the possibility of hyperinflation when a country prints its own currency. However, most developed countries have experienced only moderate bouts of inflation. Earlier in U.S. history, the country’s currency was backed by gold (and in some cases, silver). The federal government stopped allowing citizens to exchange currency for government gold with the passage of the Emergency Banking Act of 1933. The gold standard, which backed U.S. currency with federal gold, ended completely in 1971 when the U.S. also stopped issuing gold to foreign governments in exchange for U.S. currency.

Countries like the UK and the US went on to embrace the gold standard, a monetary system tying a standard unit of currency to the value of a certain amount of gold. When the Great Depression and two world wars severely affected the global economy, world leaders created an international monetary system positioning the US dollar as a global currency. Fiat money is the term used to describe currencies that are backed by the government that issued them and aren’t aren’t tied to the value of a physical commodity such as gold or silver. They derive their value largely through the public’s trust in the issuers.

There are thousands of cryptocurrencies, including Bitcoin, which some call “digital gold.” Some cryptocurrencies, called stable coins, can be pegged to commodities or fiat money, which is intended to make them less volatile. Some cryptocurrencies have utility, such as transferring payments or powering decentralized networks and applications. The advent of cryptocurrencies has spurred a debate about the future of fiat currencies and whether they’ll ultimately give way to digital coins. Cryptocurrencies such as Bitcoin aren’t fiat money because they aren’t issued, controlled, or backed by any central authority. And in some cases, the total maximum supply is designed to be capped at a certain amount.

  1. The gold standard, which backed U.S. currency with federal gold, ended completely in 1971 when the U.S. also stopped issuing gold to foreign governments in exchange for U.S. currency.
  2. The government began printing banknotes with higher values to keep up with inflation.
  3. Fiat money is physical money—paper or coins—while representative money is a check or other form of currency that can be exchanged for physical money in a stated amount.
  4. From there, governments began issuing paper currency, or notes that were redeemable for a measure of the backing standard.

Worries about inflation and government control over money and economic policy have led many people to consider cryptocurrencies. As a decentralized digital asset, cryptocurrencies are very appealing to anyone who is suspicious of government manipulation of money. They are also becoming increasingly useful as portable, digital stores of value. And, as we have seen over the past several years as many have gained immensely in value, they can hedge your wealth against inflation. Increasing the money supply may sound like a central bank, such as the U.S.

Fiat money originated from China in the 10th century, mainly in the Yuan, Tang, Song, and Ming dynasties. In the Tang Dynasty ( ), there was a high demand for metallic currency that exceeded the supply of precious metals. The people were familiar with the use of credit notes, and they readily accepted pieces of paper or paper drafts. Another https://www.tradebot.online/ advantage of a fiat currency is that it can be used to support volatility in an economy, including supporting debt markets. A central bank can take assets on its own balance sheet, such as the Fed’s purchase of U.S. federal debt and mortgages. Moreover, it is unclear whether or not hyperinflation is caused by “runaway printing” of money.

Pros and cons of fiat money

Governments use fiat money to create economic stability and help protect against the booms and busts that are natural parts of the business cycle. However, the overproduction of fiat money risks inflation or even hyperinflation by increasing supply beyond demand. The U.S. dollar is considered to be both fiat money and legal tender, accepted for private and public debts. Legal tender is basically any currency that a government declares to be legal. Many governments issue a fiat currency, then make it legal tender by setting it as the standard for debt repayment.

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And while the amount of gold on earth hasn’t increased much over billions of years, the human population, its economic output, and the demand for money certainly have gone up. The African nation of Zimbabwe provided an example of the worst-case scenario in the early 2000s. In response to serious economic problems, the country’s central bank began to print money at a staggering pace, resulting in hyperinflation. Fiat money has been the dominant form of currency since the United States, and then the rest of the world, dropped the gold standard in the 1970s.

The pros of a fiat currency

The original notes during the Yuan Dynasty were restricted in area and duration as in the Song Dynasty. Unlike the traditional commodity-backed currencies, fiat currency cannot be converted or redeemed. For a fiat currency to be successful, the government must protect it against counterfeiting and manage the money supply responsibly.

Instead, fiat money derives its value from the trust people place in the governments that issue it. Commodity-based currencies were volatile due to the regular business cycle and periodic recessions. The central banks can print or hold paper money as they may need, giving them greater control over the money supply, interest rates, and liquidity. For example, the Federal Reserve’s control over the money supply and demand enabled it to manage the Global Financial Crisis of 2008 from causing greater harm to the U.S. financial system and global economy.

What is Fiat Money?

Fiat, however, is inconvertible and cannot be redeemed simply because there is no underlying commodity backing it. Federal Reserve has the dual mandate to keep unemployment and inflation low, and using fiat money can help it meet those goals. A fiat-money currency greatly loses its value should the issuing government or central bank either lose the ability to, or refuse to, continue to guarantee its value.

Cryptocurrencies and fiat money

The major appeal of representative money was that it was not influenced by inflation. Governments were only able to print money up to the value of the gold they held in their vaults. Before you say, “Falling prices are good,” remember that there’s a producer on the other side of every purchase. Falling prices can be disastrous for producers, especially if they happen quickly. This can result in big economic shocks, forcing companies to cut costs, lay off workers, or take other actions to stave off losses in a deflationary environment.

But there are still other forms of representative money, such as checks, money orders, and bank drafts, that can be exchanged for the value listed on the instrument. While fiat money doesn’t have intrinsic value, its value is set by the government that issues the currency. Fiat money can be used to buy goods and services because both parties involved in a transaction agree on the currency’s value. Time will tell how cryptocurrencies will ultimately be used for financial transactions, and where they’ll eventually fit in the international monetary system. For now, keep an eye on the developments and consider the pros and cons of fiat money when making decisions about saving and investing.

History of Fiat Money

The value of fiat money depends on supply and demand and was introduced as an alternative to commodity money and representative money. Commodity money is created from precious metals such as gold and silver, while representative money represents a claim on a commodity that can be redeemed. A common misconception is that, unlike currencies of the past that were based on a gold, silver, or other precious metal standard, fiat currencies don’t have “anything” backing them. Before fiat currency came about, governments would mint coins out of a valuable physical commodity, such as gold or silver, or print paper money that could be redeemed for a set amount of a physical commodity.

From 1944 to 1971, the Bretton Woods agreement fixed the value of 35 United States dollars to one troy ounce of gold.[28] Other currencies were calibrated with the U.S. dollar at fixed rates. The U.S. promised to redeem dollars with gold transferred to other national banks. Trade imbalances were corrected by gold reserve exchanges or by loans from the International Monetary Fund (IMF). Colonial powers consciously introduced fiat currencies backed by taxes (e.g., hut taxes or poll taxes) to mobilise economic resources in their new possessions, at least as a transitional arrangement. The repeated cycle of deflationary hard money, followed by inflationary paper money continued through much of the 18th and 19th centuries. Often nations would have dual currencies, with paper trading at some discount to money which represented specie.

The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on Fool.com, top-rated podcasts, and non-profit The Motley Fool Foundation. Other theories of money, such as the credit theory, suggest that since all money is a credit-debt relation, it does not matter if money is backed by anything to maintain value. The most notable currency not included in this table is the Chinese yuan, for which the statistics are listed as “not available”. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs.