Fiat Money - Explained
What is Fiat Money?
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What is Fiat Money?
Fiat is a word in Latin that means let us do it our way, or it shall be. In economics, fiat money or fiat currency is money that obtains its value from a governments legal tender, rather than from a physical commodity like gold or silver. The value of fiat currency goes hand in hand with the economic strength of its issuing government. Countries all over the world invest, save, or purchase goods and services using fiat currency. All the current paper currencies that countries use like the Euro, the US Dollar, the Japanese Yen, and other currencies are examples of fiat money. The commodity-based systems and the gold standard, the creators of the legal tender are now less functional as fiat currency now dominates the market.
The future of fiat money and the commodity-based currency is not certain, because the history of fiat money shows that the currency has some weaknesses. Fiat money is a good form of currency if the government uses it to perform its economic activities. However, people are exploring other forms of currency, such as the cryptocurrency, which are less restrictive in the market worldwide.
Why is Fiat Money Valuable?
Fiat money is valuable only because it is the duty of the government to main that value, or because the transacting parties have an agreement on the value. No one can convert or redeem fiat currency for gold or silver, and for this reason, inflation or hyperinflation may cause it to lose its value. When people no longer trust a nations currency, then it means the currency is no longer valuable.
The Rise of Fiat Money
China was the first country to use fiat money centuries ago. In the 11th century, the Szechuan province in China started distributing paper money in the market. In the beginning, they allowed the exchange of money for gold, silver, or silk. Eventually, in the 13th century, when Kublai Khan was the leader, the fiat currency system was established. However, due to overspending and hyperinflation, the Mongol Empire fell. In the 17th century, Europe started using fiat money after Sweden, Spain, and the Netherlands adopted it. The Swedish government later abandoned fiat money and went back to the silver standard because it failed greatly. In the next centuries, America, New France, and the U.S. Federal government also adopted fiat money, each having different experiences. The U.S. eventually went back and continued used commodity-based currency, swapping paper money for gold. With President Nixon in power in 1972, the U.S. permanently switched to fiat currency, abandoning the commodity-based system. The entire globe then began switching to using fiat currency.
Fiat Currency versus the Gold Standard
The governments could allow the conversion of paper currency into gold with the gold standard system. A certain amount of gold was enough to back any paper money that the government holds. Governments and banks were allowed to introduce a new currency and redeem them using a certain amount of gold. The commodity-based system had the capabilities of introducing currency and increasing its value depending on the supply and demand of the commodity. Contrary to that, fiat money does not allow conversion of currency to a commodity or anything else. The central banks and the government have full control of the fiat currency system. They control demand and supply in the market by using financial tools such as a bank reserve to deal with various financial crises. Supporters of the commodity-based system claim that the gold standard is more robust than the fiat currency system because it has a physical commodity to back it up. On the other hand, fiat advocates counter that saying that gold prices are not stable at all. The value of both fiat currency and the gold standard can vary, but fiat currency is more stable because the government has full control.
Pros and Cons of Fiat Money
Not all financial experts and economists support the use of fiat money and argue that this currency system has its advantages and disadvantages.
- Scarcity: Physical commodities like silver or gold do not impact or limit the availability of fiat money.
- Production cost: The cost of producing fiat money is less than the cost of producing commodity-based currency.
- Convenience: Fiat money does not require protection, large storage reserves, or monitoring, but gold and silver would.
- Responsiveness: With fiat money, central banks and governments have the flexibility of dealing with economic crises.
- International trade: Countries around the globe use fiat money and this makes it acceptable when doing business internationally.
- Non-Intrinsic value: Fiat money lacks intrinsic value. Governments may end up making too much of it, leading to hyperinflation, which may destroy the country's economy.
- Legal Tender
- Gresham's Law
- Functions of Money
- Gold Exchange Standard
- Bretton Woods System
- Fiat Money
- Monetary Base
- How Do Banks Create Money?
- Bank Balance Sheet
- Velocity of Money
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- Dove & Hawk (Monetary Policy) - Explained
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- The Effect of Monetary Policy on Interest Rates
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- Equation of Exchange (Economics)
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- What are Excess Reserves?
- Unpredictable Movements of Velocity
- Central Banks - Unemployment and Inflation
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- Quantity Theory of Money
- European Capital Market Institute