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. Also, coins facilitate transactions, which are made of precious metal or copper.
The next evolution was the gold standard. Under the gold standard, banknotes were backed by gold. Under this standard, if you own paper money, it would be the same as holding gold. You can 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 fiat money works
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 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, 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.
Difference between fiat money and 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, these banknotes are also valuable because you can exchange them for some 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. Money’s purchasing power for goods and services is falling rapidly. People become distrustful and reluctant to hold onto money.
That is the reason why, in modern economies, fiscal and monetary functions operate separately. The national government performs a fiscal function (regulates taxes, government spending, and national debt). Meanwhile, the monetary function (which regulates 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, you can use the money 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. The company deferred payment of principal until maturity. And 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 credit from the government. The central bank prints and guarantees it as a 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 the 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 carry out a function of storing value. The purchasing power of money for goods and services falls in a short time, making people unwilling to hold onto money.
Advantages and disadvantages of fiat money
Advantages of fiat money are:
- Widely accepted. We can use it not only for domestic transactions but also for international transactions. Fiat money is widely accepted worldwide for the purchase of almost any good or service. You can exchange it for foreign fiat currency when on vacation, traveling, or sending money worldwide.
- More practical. You can carry several banknotes with you when traveling, which is more practical than having to pocket some gold coins.
- More growth. Fiat money promotes more economic growth and activity. The government can easily print new money and increase the money supply to stimulate economic growth. On the other hand, commodity money does not have such an advantage. For example, minting more gold coins is difficult because gold reserves are limited, and not all countries have them.
Meanwhile, some of the disadvantages of fiat money are:
- Susceptible to inflation. Hyperinflation, for example, causes confidence in the currency to fall. Its purchasing power of goods and services falls in a short time.
- Printing monopoly. The central bank acts as the sole supplier. How much new money should be printed depends on the discretionary decision of the central bank. Printing too much money will lead to hyperinflation. So, suppose the central bank loses its ability or refuses to continue to guarantee its value. In that case, fiat currency will no longer be valuable.
