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What’s it: Fiat money is a currency with no intrinsic value but is a legal tender in an economy. An example of fiat money is paper money. The face value of fiat money is what you see, and it appears on the paper. Meanwhile, its real value is how many goods or services you can buy with it.
China used fiat currency around the 10th century AD. Coins, made of precious metal or copper, facilitate transactions.
The next evolution was the gold standard. Under this standard, banknotes were backed by gold. Owning paper money was the same as holding gold. You could exchange these banknotes for gold at a fixed quantity. However, the gold standard was coming to an end.
Fiat money became popular in 1971 after US President Richard Nixon introduced a law stopping US dollars’ conversion to gold. In 1976, the United States officially adopted pure banknotes and abandoned the gold standard. Since then, fiat money has continued to increase in use.
Today, most countries use paper-based fiat money. Unlike commodity money, fiat currency cannot be converted to gold.
How does fiat money work?
Fiat money is unbacked by a specific physical commodity, such as gold or silver. The paper money you use gets its value because the government declares it a legal tender. These guarantees make everyone believe it is valuable, and they can use it for various transactions.
In the modern economy, fiat money acts as an alternative to the barter economy. Through it, you can buy the products and services you need without having to exchange goods for goods, as in the barter system.
Fiat money facilitates various transactions, and everyone accepts it. For example, companies use it to buy new equipment and recruit and pay employees. Suppliers and staff are willing to accept paper money as a means of payment. They then use it to buy inputs and shop for goods and services.
Fiat money vs. Commodity money
In the past, money was made of precious metals such as gold and silver. That is an example of commodity money. Some of the other commodities used are copper, cocoa beans, salt, and pepper. Commodity money has intrinsic value, namely the use of these commodities in our daily lives.
Likewise, we all agree that gold and silver are valuable. So, making it a means of payment makes sense, and everyone accepts it. Also, gold coins are a reliable store of value with a long shelf life and little depreciation risk.
Under the gold standard, money in circulation was paper money and had no intrinsic value. However, banknotes are also valuable because they can be exchanged for gold.
After the gold standard collapsed, paper money (fiat money) was no longer supported by any commodity. Thus, fiat money has no intrinsic value because the paper to make it is worth much less than the nominal stated on the banknote. We consider it valuable because the government guarantees it as legal tender. So, everyone is willing to accept and use it in economic transactions.
Fiat money supports economic stability because the government controls the money supply. That way, money can retain its value over time.
But if the government prints too much, for example, to pay debts, it will jeopardize the economy’s stability. A drastic increase in the money supply gives rise to hyperinflation, which rapidly reduces money’s purchasing power for goods and services. People become distrustful and reluctant to hold onto money.
That is why fiscal and monetary functions operate separately in modern economies. The national government performs a fiscal function (regulating taxes, government spending, and national debt). Meanwhile, the monetary function (regulating the money supply) is under the control of the monetary authority or the central bank.
Fiat money function
Fiat money works well as money in the economy if it can handle three critical roles: medium of exchange, store of value, and units of account.
- Medium of exchange. You can use it to pay for goods and services without exchanging goods for goods, as in bartering transactions. You only need to take money out of your pocket for the price of the product to pay.
- Unit of account. You can use the money to determine the monetary value of goods, services, and other transactions. When producing goods, you can set the price of the goods at a certain nominal value.
- Store of value. You can use it to save wealth. In the future, you make money for various transactions. Long story short, through money, you can transfer the present wealth to the future. To do so, the value of money must remain stable over time.
Economists also consider an additional function, namely, as a standard of deferred payment. In this case, money can be used to value debt. This function is a direct result of the store of value and the unit of account functions.
For example, when a company issues debt securities with a principal of $1,000 and a tenor of 5 years, it defers payment of the principal until maturity. After five years, the company will spend $1,000 to pay off its debt.
The function of fiat money above works well if the economy is in ideal conditions. The public has sufficient confidence in currencies’ ability to act as a means of payment and use them in various transactions. It must be supported by full government credit. The central bank prints and guarantees it as legal tender for economic transactions. Also, the central bank must protect it from counterfeiting and manage the money supply responsibly.
When experiencing economic and political instability, a country may see its confidence in its currency weaken. For example, when hyperinflation is high, people will no longer trust the domestic currency.
Although it still functions as a medium of exchange and a unit of account, fiat money is not good enough to store value. The purchasing power of money for goods and services falls quickly, making people unwilling to hold onto money.
Advantages of fiat money
Fiat money offers several advantages that contribute to a smooth-functioning economy and international trade. Here’s a closer look at three key benefits:
Global acceptance: a currency for a connected world
Fiat money acts as a universally accepted form of payment, unlike some commodity-based currencies. This widespread acceptance makes it incredibly convenient for international transactions.
Whether you’re a tourist visiting Europe or a company sending funds to an overseas supplier, fiat money allows you to conduct business with ease. You can exchange your domestic currency for local fiat money wherever you go, ensuring a familiar and reliable medium of exchange on the global stage.
Convenience that carries weight (literally)
Compared to commodity money like gold or silver coins, fiat money is far more practical for everyday use. Carrying a few bills or swiping a credit card is much easier than lugging around a pouch full of heavy coins.
This portability makes fiat money ideal for daily transactions, both big and small. Additionally, the ease of storing and transporting large sums of fiat money facilitates domestic and international trade. Businesses don’t have to worry about the logistics of securely moving vast quantities of precious metals.
A tool for growth: stimulating economic activity
Fiat money empowers governments to play a more active role in managing economic growth. Unlike commodity money, which has limited or slow-growing supplies, fiat money allows central banks to adjust the money supply as needed.
During economic downturns, central banks can increase the money supply by printing more currency or lowering interest rates. This injects additional money into the economy, encouraging borrowing, investment, and spending, which can help stimulate growth. This flexibility in managing the money supply is a powerful tool for governments to promote economic health and stability.
Disadvantages of fiat money
While fiat money offers advantages, it also comes with drawbacks that require careful management by governments and central banks. Here are three key challenges to consider:
The inflation threat: erosion of value
One of the biggest concerns with fiat money is its vulnerability to inflation. If a central bank prints too much money, it can exceed the growth rate of goods and services in the economy. This excessive money supply reduces the value of each individual unit of currency.
In extreme cases, this can lead to hyperinflation, where prices soar rapidly, eroding people’s purchasing power and savings. Imagine you save up money to buy a new car, but due to hyperinflation, by the time you have enough, the price of the car has skyrocketed, leaving you unable to afford it. This loss of value discourages saving and investment, hindering economic growth.
The Central bank balancing act: printing with caution
Central banks hold the power to print money, but this power comes with significant responsibility. If they print too little, it can stifle economic growth. However, printing too much carries the risk of inflation.
This creates a delicate balancing act for central banks, which must strive to maintain a stable money supply that supports economic activity without triggering inflation.
Trust underpins value
Fiat money’s value ultimately relies on public trust in the issuing government and central bank. If people lose faith in the currency’s ability to hold its value, they may become hesitant to use it or may seek alternative stores of value, such as gold or foreign currencies.
This loss of confidence can lead to a downward spiral, as people spend their money quickly to avoid holding onto a depreciating asset. This can disrupt economic activity and create further instability.
