Updated Feb 17, 2022

What is Fiat Money?

What is Fiat Money?

A government-issued currency is known as fiat money. It is not backed by a physical commodity, like silver or gold, but by the government that declared it. The value of fiat money is determined by the relationship between supply and demand and the overall stability of the government. It is not determined by the worth of any commodity backing it. The most well-known modern paper currencies are fiat currencies,

Importance of Fiat Money

• Fiat money has the potential to be more stable than commodities as a form of money. This is due to a consistent supply provided by the central bank or government – whoever is in charge.
• Since fiat money is not a scarce or fixed resource like gold, central banks have far greater control over its supply, allowing them to manage economic variables like credit supply, liquidity, interest rates, and money velocity.
• Fiat money is a good currency if it can perform the functions that a country's economy requires of its monetary unit, such as storing value, providing a numerical account, and facilitating exchange.
• It is less expensive to produce than a currency that is directly linked to a commodity.
• Fiat money gives governments more leeway in managing their own currency, setting monetary policy, and stabilizing global markets.
• It also permits fractional reserve banking, which allows commercial banks to multiply the amount of money on hand to meet borrowers' demands.

Limitations of fiat Money

• Monetary policies that reduce the value of money result in overprinting of currency, which may result in hyperinflation.
• It is still bulky to carry, reducing its movability.
• Theft risk and vulnerability to counterfeit (duplicate/fake currency)
• Money cannot be easily divided into small increments to more precisely match commodity values, which leads to the rounding-off problem.
• For example, due to a change problem, petrol pumps are not returning 60 paise per customer.
• Hyperinflation occurs when inflation rises at an extremely rapid rate. Inflation rates can rise from 50 to 300 times.
• If people lose faith in a country's currency, the money loses its value. This is not the same as a gold-backed currency.
• The 2007 mortgage crisis and subsequent financial meltdown, on the other hand, tempered the belief that central banks could always prevent depressions or severe recessions by regulating the money supply.
• Due toits unlimited supply, fiat money provides more opportunities for the creation of bubbles.

History of Fiat Money

Fiat money originated from China in the 10th century, mainly in the Yuan, Tang, Song, and Ming dynasties. In the Tang Dynasty (618-907), 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.

A shortage of coins forced people to change from coins to notes. During the Song Dynasty (960-1276), there was a booming business in the Sichuan region that led to a shortage of copper money. Traders started issuing private notes covered by a monetary reserve, and it was considered to be the first legal tender. Paper money became the only legal tender in the Yuan Dynasty (1276-1367), and issuing of notes was conferred to the Ministry of Finance during the Ming Dynasty (1368-1644).

The West started using paper money in the 18th century. American colonies, France, and the Continental Congress started issuing bills of credit that were used to make payments. The provincial governments issued notes that the holders would use to pay taxes to the authorities. The issuing of too many bills of credit generated some controversy due to the dangers of inflation.

In some regions, such as New England and the Carolinas, the bills depreciated significantly and there was a hike in commodity prices as the bills lost value. During wars, countries turn to fiat currencies to preserve the value of precious metals such as gold and silver. For example, the Federal Government of the United States turned to a form of fiat currency referred to as “Greenbacks” during the American Civil War. The government halted the convertibility of its paper money to gold or silver during this war.

In the early 20th century, the government and banks had promised to allow the conversion of notes and coins into their nominal commodity on demand. However, the high cost of the American Civil War and the need to rebuild the economy forced the government to cancel the redemption.

The Bretton Woods Agreement was reached in a 1944 summit held in New Hampshire, USA on a site by the same name. fixed the value of one troy ounce of gold to 35 United States Dollars. However, in 1971, United States President, Richard Nixon, introduced a series of economic measures including canceling the direct convertibility of dollars into gold due to declining gold reserves. Since then, most countries have adopted fiat monies that are exchangeable between major currencies.

How Does Fiat Money Work?

Fiat currency is not supported by any physical commodity, but by the faith of its holders and virtue of a government declaration. Paper money acts as a storage medium for purchasing power and an alternative to the barter system. It allows people to buy products and services as they need without having to trade product for product, as was the case with barter trade.

Due to its ability to store purchasing power, people can make plans with ease and create specialized economic activities. For example, a business dealing with mobile phone assembly can buy new equipment, hire and pay employees, and expand into other regions.

The value of fiat money is dependent on how a country’s economy is performing, how the country is governing itself, and the effects of these factors on interest rates. A country experiencing political instability is likely to have a weakened currency and inflated commodity prices, making it hard for people to buy products as they may need.

A fiat currency functions well when the public has enough confidence in the currency’s ability to act as a storage medium for purchasing power. Also, it must be backed by the full credit of the government that gives a decree and prints it as a legal tender for financial transactions.

Pros and cons of a fiat currency

Pros of a fiat currency

Since fiat money is not a scarce or fixed resource – like gold – a country’s central bank has greater control over its supply and value. This means that governments can manage the credit supply, liquidity and interest rates more reliably.

Unlike commodity currencies, which could be affected by the discovery of a new gold mine, the supply of fiat currencies is regulated and controlled by the respective currency’s government. There is less risk of an unexpected devaluation caused by the supply of fiat currencies, as any increase in supply is a pre-empted decision made by a fiat currency’s government.

Cons of a fiat currency

Since it is not tied to a tangible asset, the value of fiat money is dependent on responsible fiscal policy and regulation by the government. Irresponsible monetary policy can lead to inflation and even hyperinflation of a fiat currency.

Adding to this, there is greater opportunity for bubbles with fiat currency – an economic cycle in which there is a rapid increase in price before an equally rapid decline in price.

The increased prevalence of bubbles is because fiat currencies have a virtually unlimited supply, which means that quantitative easing is an option for governments. While possibly providing stimulus to an economy, quantitative easing can also cause greater inflation rates. This could impact anything from housing prices to national debt levels, which in turn could impact the financial markets.

Conclusion

Fiat currencies have value only because the government maintains it; there is no utility to fiat money in and of itself. Since there is no underlying commodity backing fiat money, it is inconvertible and cannot be redeemed.