Fiat Money simply explained
Fiat currencies are government-issued national currencies, such as the U.S. dollar, euro, or Swiss franc, that are not backed by the value of precious metals such as gold or silver. Instead, their value is derived from the existence of the government and the national bank that issued them.
What is Fiat Money?
Fiat money is a legal tender issued by governments and central banks. Today, most countries in the world use a fiat currency system, with the strength and value of the currency usually dependent on the economic and political strength of the country.
The term fiat money originates from the Latin fiat lux, meaning «let there be light». Fiat money, meaning «let there be money», does not include a fundamental value. Instead, its market value is based on the future expectations of market participants.
The Far-Reaching Abolition of the Gold Standard
When Richard Nixon, then President of the United States, decoupled the U.S. dollar from the price of gold in 1971, unbacked fiat money was born. Since then, most countries have issued their own fiat currencies and continue to use them today.
> Learn more about the Bretton Woods System
Fiat Money is based on Trust
Fiat money, then, is a government-determined medium of exchange and payment that has no real intrinsic value. However, the state, or rather the central bank, creates banknotes and coins to which a value is assigned. Through this hypothetical value, a certain value is attributed to the fiat currency.
Thus, fundamentally, the value of fiat money is based on the public's trust in the government or central bank. It is thus a matter of the government's promise that goods and services can be purchased with the respective currency in the future.
It is crucial that citizens believe in the purchasing power of the currency. If the government and central banks fail, then the state fiat currency also automatically loses value and, in the worst case, becomes completely worthless.
Control over the Economy
The fiat currency is not only dependent on the government, but through the currency the state also has great control over the economy and much power to influence it.
Through monetary policy measures, such as changing interest rates and setting reserve requirements for banks, the government can greatly influence the national currency.
The main problem with conventional currencies is the trust required to make them work. You have to trust the central bank not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles without being able to set aside even a fraction of it. We have to trust them with our privacy and trust that they won't let identity thieves raid our accounts. Their massive overhead costs make micropayments impossible.
Inflation as a Feature
The main feature of a fiat currency is continuous inflation. Since the central bank can create money out of thin air to finance spending, the fiat currency's money supply is constantly increasing. This dilutes the supply and decreases the purchasing power of the currency over time.
Fiat currencies in healthy economies typically have annual inflation rates of about 2%. However, the inflation rate is affected by economic events.
For example, in response to the COVID-19 crisis, many countries dramatically increased the money supply with expansionary monetary policies. Which ultimately led to excessive inflation. In extreme cases, a fiat currency can end up in hyperinflation, losing its monetary function as a medium of exchange.
The best example of this is illustrated by the Venezuelan bolivar, which recently ended in hyperinflation. As the bolivar lost much of its value due to severe inflation and could no longer be used as a medium of exchange, citizens wove handbags out of the worthless paper notes. Thus, paper as a commodity had greater utility or value at that time than money per se.
Advantages of Fiat Money
Because fiat money is not a scarce or limited resource, like gold or bitcoin, a government's central bank has more control over its value. This means that governments can manage the supply of credit, liquidity, and interest rates more reliably and flexibly.
So, with these means, the government can influence the currency and thus, for example, revive the economy and the financial center during crises.
Disadvantages of Fiat Money
Since fiat money is not tied to a tangible asset, its value depends on the responsible fiscal policy of the government and the central bank. Thus, the failure of monetary policy can lead to high inflation and even hyperinflation of a fiat currency.
What does Fiscal Policy mean?
Fiscal policy is an economic policy instrument of the state, which attempts to balance out economic fluctuations by influencing taxes and government spending. This is intended to ensure stable economic growth.
Further goals of the fiscal policy are a high employment level of the population, as well as a steady and low inflation around 2 %.
> Learn more about Fiscal Policy
Fiat Money vs. Commodity Money
An alternative to fiat money is commodity money. This is because, unlike fiat-, commodity money, for example the precious metals gold and silver, or commodities such as salt, tobacco, or shells, has some intrinsic value in the form of the commodity itself, in addition to its exchange value. This is usually a resource that can be consumed or used.
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