What Exactly Is Fiat Money?
The currency that the government issues is fiat money, which has no physical backing in gold or silver. Instead of a commodity backing it, supply and demand and government stability determine the value of this money.
Fiat currencies like the U.S. dollar, euro, and others are common today.
Understanding Fiat Money
Latin “fiat” means “it shall be” or “let it be done.” Fiat currencies only have value because the government sustains them; they have no intrinsic worth.
Before fiat currency, governments would produce coins from gold or silver or issue paper money that could be exchanged for a defined sum. Without a supporting commodity, fiat is inconvertible and cannot be redeemed.
This money is not connected to actual assets like gold or silver; hence, it can lose value owing to inflation or become worthless in hyperinflation. Some of the worst hyperinflation, such as in Hungary after WWII, might double daily.
If people lose trust in a country’s currency, it loses value. In contrast, a gold-backed currency has inherent value due to the demand for gold in jewelry, ornamentation, electronics, computers, and aeronautical vehicles.
U.S. Fiat Money History
The U.S. dollar is the legal currency for private and public obligations and fiat money. Legal tender is any government-approved money. By making fiat currencies the benchmark for debt payments, many governments render them legal tender.
Gold and silver supported U.S. money in the past. The 1933 Emergency Banking Act banned residents from exchanging cash for government gold. In 1971, the U.S. stopped distributing gold to foreign countries in return for U.S. money, ending the gold standard.
Since then, U.S. dollars have been “full faith and credit” of the government, “legal tender for all debts, public and private,” but not “redeemable in lawful money at the United States Treasury or at any Federal Reserve Bank,” as printed on dollar bills. Thus, U.S. dollars are now “legal tender,” not “lawful money,” and can be exchanged for gold, silver, or other commodities.
Advantages and Disadvantages of Fiat Money
Advantages
- Increases central bank economic control
- Economical to make
- Gives governments flexibility
Disadvantages
- Not guaranteed to protect the economy.
- Makes bubbles possible
- Provides inflation risk
Explained Benefits
Fiat currencies were popular in the 20th century because governments and central banks wanted to protect their economies from business cycle booms and busts.
Since fiat money is not scarce or fixed like gold, central banks may regulate economic factors, including credit availability, liquidity, interest rates, and money velocity. This money can help the U.S. Federal Reserve reach its unemployment and inflation targets.
A nation’s economy needs a currency that stores value provides a numerical record, and facilitates transactions. It has excellent segregation, making it cheaper to manufacture than commodity-linked money.
Disadvantages Explained
The 2007 housing crisis and financial catastrophe reduced central banks’ capacity to prevent depressions or significant recessions by controlling the money supply.
Due to the restricted quantity of gold, gold-backed currencies are more stable than fiat money.
Fiat money’s infinite supply allows for additional bubbles.
Examples of Fiat Money
U.S. dollars, euros, British pounds, Japanese yen, and Indian rupees are fiat currencies.
A government-backed currency like fiat money typically stabilizes the economy, but not always.
Zimbabwe in the early 2000s was the worst-case scenario. In response to severe economic issues, the central bank printed money alarmingly, causing hyperinflation.
Experts estimate the currency lost 99.9% of its worth. Consumers brought bags full of money to buy the basics while prices soared dramatically. Zimbabwe had to produce a 100-trillion-dollar note during the crisis. Foreign currencies eventually replaced the Zimbabwean dollar.
Why is fiat money necessary?
Fiat money has no other backing than the government that issued it, unlike gold coins or paper notes redeemable for precious metals. This is valid since governments require fiat currency taxation. People tolerate taxes because they must pay them or risk jail time (capitalism).
Another theory of money, the credit theory, holds that all money is a credit-debt connection; hence, it doesn’t matter what backs it.
Why Do Modern Economies Prefer Fiat Money?
Before the 20th century, most nations used a gold standard or commodity backing. Although worldwide trade and finance developed, the restricted amount of gold pouring out of mines and into central bank vaults could not keep up with the additional value generated, disrupting global markets and business.
Governments can better control their currencies, determine monetary policy, and stabilize global markets with fiat money. It facilitates fractional reserve banking, which lets commercial banks duplicate their cash to fulfill borrower demand.
What are fiat money alternatives?
Most nations use this money as legal tender. Gold and gold coins can be bought and sold; however, they are primarily utilized as collectibles or speculative assets.
Over the past decade, cryptocurrencies like Bitcoin have challenged fiat currencies’ inflationary character, but despite rising interest and adoption, they do not seem to be “money” in the classic sense.
Does fiat money cause hyperinflation?
Hyperinflation is possible when a government issues its currency. However, most wealthy nations have seen mild inflation. Having steady, low inflation encourages individuals to invest their money rather than let it lie idle and lose buying power, which boosts economic growth and investment.
Most modern central banks require a solid and stable currency, as a rapidly depreciating currency hinders commerce and finance.
Hyperinflation may not be triggered by the “runaway printing” of money. Hyperinflation has happened throughout history, even when money was based on precious metals, and all modern hyperinflation has started with a fundamental collapse in the actual production sector and political upheaval.
Final Thought
Supply and demand determine the value of fiat money, unlike tangible goods. Governments utilize this money to stabilize the economy and prevent business cycle booms and busts. Overproducing fiat money threatens inflation, or hyperinflation, by exceeding demand.
Conclusion
- A government-issued currency without gold backing is called fiat money.
- Since central banks can issue money, this currency offers them more economic power.
Most current paper currencies, like the dollar, are fiat. - Governments can issue too much fiat money, causing hyperinflation.
