- Fiat money is currency backed by the government that issued it and isn't tied to a commodity such as gold.
- Fiat money issuers can have a lot of influence on the economy by controlling the supply of this currency.
- Overly aggressive monetary policies run the risk of eroding the value of fiat currencies.
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Fiat money is the term used to describe currencies that are backed by the government that issued them and aren't aren't tied to the value of a physical commodity such as gold or silver. They derive their value largely through the public's trust in the issuers.
Most of the currency in the world is now fiat money. It began to see widespread use in the 20th century when the US dollar was decoupled from the price of gold. With the advent of cryptocurrencies such as Bitcoin, there's been debate about whether such digital assets could ultimately supplant fiat money as the preferred medium of exchange, or at least provide an alternative.
How does fiat money work?
You've probably heard the expression, "Backed by the full faith and credit of the US government," in reference to the dollar. That's the principle behind fiat money. It gets its value based on the trust people place in the authorities that issue it. Commodity-backed currencies, on the other hand, get their value from the underlying price of the gold, silver, or other materials they're linked to.
Today, most money in the world is fiat money. In the US, the Federal Reserve controls the supply of dollars. The European Central Bank controls the supply of the euro common currency. Those are two of the most well-known fiat currencies.
This money is legal tender, but it has no intrinsic value. In essence, it has value because the authorities that issued it say it does. Its value can be largely determined by how the issuer's economy performs. And it allows central banks to have a lot of influence on the economy because they can control the money supply.
Why do most countries use fiat money today?
The use of commodity money has been common throughout history. Coins made from precious metals like silver and gold were the standard for thousands of years. By the 18th and 19th centuries, paper currencies began to take hold, although many of them served as promissory notes to pay specific quantities of gold and silver.
Countries like the UK and the US went on to embrace the gold standard, a monetary system tying a standard unit of currency to the value of a certain amount of gold. When the Great Depression and two world wars severely affected the global economy, world leaders created an international monetary system positioning the US dollar as a global currency.
International balances were settled in dollars, which were convertible to gold at a fixed exchange rate. The gold standard was in place until 1971, when US President Richard Nixon, faced with surging inflation and high unemployment, ended it as the amount of foreign-held dollars exceeded the amount of gold in the US reserves.
The pros and cons of fiat money
Fiat money's relative stability and the ability of central banks to control the supply and manage the economy is one of its biggest advantages. However, those efforts aren't always successful, and some critics argue that instead of providing a cushion against economic shocks, fiat currencies can sometimes exacerbate them if policy makers print too much money.
"Like with any incumbent technology for an existing system, it kind of mostly works most of the time," says Andy Edstrom, managing director with Swan Advisor Services and author of, "Why Buy Bitcoin: Investing Today in the Money of Tomorrow." But, as inflation rises, and more fiat units are printed, "the cracks are starting to appear in the system," he says.
Cryptocurrency vs. fiat money
The advent of cryptocurrencies has spurred a debate about the future of fiat currencies and whether they'll ultimately give way to digital coins. Cryptocurrencies such as Bitcoin aren't fiat money because they aren't issued, controlled, or backed by any central authority. And in some cases, the total maximum supply is designed to be capped at a certain amount.
The price volatility of cryptocurrencies is one reason some skeptics say it is unlikely to supplant fiat money as the dominant medium of exchange. But acceptance of crypto has been growing. For instance, El Salvador this year became the first country to make Bitcoin legal tender. PayPal now allows some users to pay for purchases with Bitcoin. Visa has partnered with crypto platforms on card programs.
There are thousands of cryptocurrencies, including Bitcoin, which some call "digital gold." Some cryptocurrencies, called stable coins, can be pegged to commodities or fiat money, which is intended to make them less volatile. Some cryptocurrencies have utility, such as transferring payments or powering decentralized networks and applications. Others are created for fun. And some others can be scams.
"It's not used as money yet, transactionally, very much, because of that short-term volatility in purchasing power," Edstrom says of Bitcoin. "But, if it reaches its potential over the next decade or two, then it's likely that the volatility will reduce, and it's likely that Bitcoin will become used commonly as money in the economy as it matures."
The financial takeaway
Fiat money is currency that's backed by the public's faith in the government or central bank that issued them and is the standard throughout most of the world. It has no intrinsic value, unlike commodity currency, which is linked to the prices of a commodity such as gold or silver. Instead, fiat money derives its value from the trust people place in the governments that issue it.
While fiat money has been the norm since the early 1970s, the emergence of cryptocurrency has some proponents of Bitcoin and certain other digital assets arguing that this new form of currency is a better medium of exchange and store of value. And it has been gaining acceptance in government and business.
Time will tell how cryptocurrencies will ultimately be used for financial transactions, and where they'll eventually fit in the international monetary system. For now, keep an eye on the developments and consider the pros and cons of fiat money when making decisions about saving and investing.
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