What is Fiat Money?
Fiat Money Definition
Fiat money is money that is issued by the government but is not backed by a physical good like gold or silver. Instead, it is backed by the government that issued it. Instead of the value of a commodity backing it, fiat money is based on the relationship between supply and demand and the stability of the government that gives it out.
Fiat Money Example
Most paper currencies in use today, such as the U.S. dollar, the euro, and other major global currencies, are fiat currencies.
Understanding Fiat Money
The Latin word "fiat" is often translated as "let it be done" or "it shall be." So, the only reason fiat currencies have value is that the government keeps that value. Fiat money has no value on its own.
When governments made coins out of a valuable physical commodity, like gold or silver, or printed paper money that could be exchanged for a set amount of a physical commodity, this was the start of fiat currency. Fiat, on the other hand, is not convertible and cannot be redeemed because it is not backed by a commodity.
Because fiat money isn't tied to physical reserves like a national stockpile of gold or silver, it could lose value due to inflation or even become worthless if hyperinflation happens. In some of the worst cases of hyperinflation, like in Hungary right after World War II, the rate of inflation can double in a single day.
Also, if people stop believing in a country's currency, it will no longer be worth anything. This is very different from, say, a currency backed by gold. It has value on its own because gold is used to make jewelry, decorations, and electronic devices, computers, and space vehicles.
History of Fiat Money in the U.S.
The U.S. dollar is both "fiat money" and "legal tender," which means it can be used to pay private and public debts. Legal tender is basically any money that the government says is okay to use. Many governments create a currency that isn't backed by anything and then make it legal by making it the standard for paying back debts.
In the past, gold was used to back the country's money (and in some cases, silver). With the Emergency Banking Act of 1933, the federal government stopped letting people trade money for government gold. The gold standard, in which federal gold backed U.S. currency, came to an end when the U.S. stopped giving gold to foreign governments in exchange for U.S. currency in 1971.
Since then, people have known that U.S. dollars are backed by the "full faith and credit" of the U.S. government and are "legal tender for all debts, public and private." However, U.S. dollar bills are no longer "redeemable in lawful money at the United States Treasury or at any Federal Reserve Bank," as they used to say. In this way, U.S. dollars are no longer "lawful money." Instead, they are "legal tender," which means they can be traded for gold, silver, or any other good.
Advantages and Disadvantages of Fiat Money
Advantages
Fiat money is a good currency if it can do what a country's economy needs from its monetary unit: store value, keep track of numbers, and make it easy to trade. It also has good seigniorage, which means that it is cheaper to make than a currency that is directly tied to a commodity.
In the 20th century, fiat currencies became more popular because governments and central banks wanted to protect their economies from the worst effects of the business cycle.
Since fiat money is not a scarce or fixed resource like gold, central banks have much more control over its supply. This gives them the power to manage economic variables like credit supply, liquidity, interest rates, and money velocity. In one case, the U.S. The Federal Reserve's job is to keep both unemployment and inflation low.
Disadvantages
The mortgage crisis of 2007 and the subsequent financial meltdown, on the other hand, made it less likely that central banks could prevent depressions or serious recessions by controlling the amount of money in the economy. Because there is a limited amount of gold, for example, a currency tied to gold is usually more stable than fiat money. Because there is no limit to the amount of fiat money, there are more chances for bubbles to form.
| Pros | Cons |
|---|---|
| This gives central banks more control over the economy. | It's not a foolproof way to protect the economy. |
| Seigniorage | Opportunity for a bubble |
| Offers flexibility | Risk of inflation |
Example of Fiat Money Gone Wrong: Hyperinflation
The African nation of Zimbabwe provided an example of the worst-case scenario in the early 2000s. Because the economy was in bad shape, the country's central bank started printing money at a crazy rate, which led to hyperinflation.
Experts say that the value of the currency dropped by 99.9% during this time. Prices went up quickly, and people had to carry around bags of cash just to buy the basics. At the height of the crisis, the Zimbabwe government was forced to print a 100-trillion Zimbabwean dollar note. In the end, more people used foreign money than the Zimbabwean dollar.
Why Is Fiat Money Valuable?
Unlike gold coins or paper bills that can be exchanged for precious metals, fiat money is only backed by faith and trust in the government that created it. One reason this makes sense is that governments make you pay taxes in the fiat money they print. Since everyone has to pay taxes or face fines or jail time, people will be willing to take it in exchange (this is known as Chartalism). Other theories of money, like the credit theory, say that since all money is a credit-debt relationship, it doesn't matter if money is backed by anything to keep its value.
Why Do Modern Economies Favor Fiat Money?
Before the 20th century, most countries had some kind of gold standard or a commodity that backed their money. As the size and scope of international trade and finance grew, the small amount of gold coming out of mines and stored in central bank vaults couldn't keep up with the new value that was being created. This caused serious problems in global markets and commerce. Fiat money gives governments more options for managing their own currencies, setting monetary policy, and stabilizing markets around the world. It also lets commercial banks use fractional reserve banking, which lets them multiply the amount of money they have on hand to meet borrowers' needs.
What Are Some Alternatives to Fiat Money?
Fiat money is used as legal tender in almost every country in the world today. Gold and gold coins can be bought and sold, but they are rarely used as money or for everyday purchases. Instead, they are more often used as collectibles or investments. In the last ten years, cryptocurrencies like Bitcoin have grown as a response to the inflationary nature of fiat currencies. However, despite growing interest and use, these virtual assets don't seem to be "money" in the traditional sense.
Does Fiat Money Lead to Hyperinflation?
When a country prints its own money, hyperinflation is always a possibility. However, most developed countries have only had mild bouts of inflation. In fact, low inflation is seen as a good thing for economic growth and investment because it encourages people to put their money to work instead of letting it sit around and lose value over time.
Most modern central banks are required to keep their currency relatively strong and stable, and a currency that loses value quickly hurts trade and makes it hard to get money. Also, it is not clear if the "runaway printing" of money is a cause of hyperinflation or not. In fact, hyperinflation has happened throughout history, even when money was based on precious metals. All modern hyperinflations have started with a fundamental breakdown in the real production economy and/or political instability in the country.
