If you’ve ever wondered what fiat currency is, you’re not alone. The concept of “fiat” money is one of the most confusing things about modern finance. Luckily, you’re in the right place, as we’ll break down the concept of fiat currency in this blog post today. But before we start, it’s essential to define what money is.
Table of Contents
- What Is Money?
- What Is Fiat Currency?
- The World’s Leading Fiat Currency
- Advantages of Fiat Currency
- How Does Hyperinflation Cause a Currency to Lose Value
What Is Money?
Money is one of the most important economic concepts. First, it’s a store of value, account unit, and exchange medium. Secondly, it can be tangible (like coins or paper bills) or intangible (like digital currency).
Money is something that people use to buy goods and services. Additionally, money can be anything people agree on as a means of payment for goods and services. Historically, this has included:
- gold coins,
- silver coins,
- banknotes (paper money),
- cheques (written orders to pay),
- credit cards and
- electronic transfers between bank accounts.
Backing Currency With Gold
All things considered, if you’re looking for stability, consider a currency backed by gold. The U.S., Britain, and France are among the few countries that still have this system in place, and for good reason.
The backing of a currency with gold has many benefits:
- it makes it harder for governments to print more money without first having to find more gold;
- it helps stabilize prices; and,
- It can reduce inflation (when there’s too much money in circulation).
The downside is that if there isn’t enough gold available, your government may have trouble paying its bills or funding its programs.
But did you know governments don’t have to back their currency with gold?
What Is Fiat Currency?
Fiat currency is a currency that a government has declared legal tender. But here’s where things get interesting: A physical commodity like gold or silver does not back this legal tender. It’s a currency backed by a government, not a physical entity.
Fiat money got its name because it was originally issued by royal decree (fiat). The term “fiat” means “let it be done,” this type of money started when kings declared legal tender gold or silver coins.
Fiat money is not the same thing as paper money. It’s important to understand that fiat currency is different from paper money. Fiat currency refers only to a government’s authority over its currency and what makes it valid in exchange for goods and services.
Examples of Fiat Money
There are many different kinds of fiat currency. The most common examples include the following:
- U.S. dollar
- Euro (the official currency of many European countries)
- British pound (also known as “sterling”)
- Japanese yen and Indian rupeeWhat Is The Worlds Leading Fiat Currency?
Did You Know That Fiat Money Has No Intrinsic Value?
Let’s clarify a few things before we get started. What is intrinsic value? In simple terms, intrinsic value is the value of an asset based on its usefulness and scarcity. I believe time has intrinsic value and is our most precious commodity. We can’t make any more of it, nor can we buy it.
So, does money have intrinsic value? So why do we care about money? Well, money lets us do things like buy a car or food. Buying a car might give us the freedom to buy food, which provides us with nourishment and pleasure. And, quite frankly, it helps to sustain our life.
But imagine we lived in an economy with hyperinflation, an economy where you couldn’t use the money for anything. At this point, paper money becomes something we can’t get any value out of because we can’t buy anything with it. In that case, most people would say paper money has no value.
The World’s Leading Fiat Currency
The U.S. dollar has been the world’s leading fiat currency since 1945. In 1945, after WWII, the Bretton Woods Agreement was signed by 44 countries. Ultimately, it gave rise to the U.S. dollar becoming an international reserve currency.
Firstly, this made it the currency of choice for most banks around the globe. Secondly, it made it the currency of choice in many nations worldwide.
Who Creates US. Dollars?
The Federal Reserve, or “the Fed,” is the central bank of the United States. Moreover, it creates U.S. dollars by buying bonds from banks. What’s more, the Fed can increase or decrease the money supply in our economy.
Why is the U.S. dollar considered Fiat money? The U.S. dollar is fiat because a physical good does not back it. It gets its value from the law establishing it as a legal tender.
There was a time when the U.S. dollar was backed by something with intrinsic value. The U.S. dollar was backed by gold until 1971 when President Nixon removed the link between the dollar and gold.
Unfortunately, this allowed the Federal Reserve to print money without having to back it up with anything. Since then, other countries have also started using fiat currencies not backed by gold or silver. Most of the world’s major economies use fiat currency as legal tender today.
Advantages of Fiat Currency
There are several advantages to fiat currency over commodity-backed currencies:
- Fiat currencies are produced efficiently and quickly compared with other forms of money, such as gold or silver coins.
- Fiat currencies have excellent seigniorage. Namely, it’s cheap to produce since you don’t need expensive materials like gold or silver. Cut some trees down, and you’re good to go.
Why Do Countries Choose Fiat Money?
There are many reasons why countries choose to use fiat currency:
- It is effortless to control and use.
- It’s easy to make, change, and print.
- People trust that what they have in their hands is worth something (as opposed to gold or silver).
- Governments use fiat money as a tool for power over their citizens and businesses.
Disadvantages of Fiat Currency
There are a few disadvantages of fiat currency. For one thing, it’s not backed by anything other than trust in government policies and confidence in the country’s institutions. Ultimately, this means that if you lose faith in a particular government or institution, your money will be worth nothing. You could also lose all of your savings due to inflation (the rate at which the value of money decreases).
Looking at history books, you’ll see that most countries had their currencies backed by gold reserves. Instead of being backed by trust and confidence alone, those gold-backed currencies were much more stable than ours!
The devastating impact of a country-backed currency has been demonstrated by the hyperinflation in Zimbabwe from 1999 to 2009. The inflation rate was so high it made their currency worthless, and they had to introduce new denominations every week so that people could buy essential goods like bread and milk.
How Does Hyperinflation Cause a Currency to Lose Value
Governments issue fiat currency and promise they will always be accepted as payment for goods or services. But this is only sometimes the case.
Take hyperinflation, when the currency’s value drops so rapidly that it becomes nearly worthless. This makes it difficult for people to buy goods and services. This happens simply because governments print too much money, causing inflation to skyrocket until prices rise at least 50% per month (sometimes even faster).
Is it unstable? As mentioned above, fiat currency derives value from government regulation or law. Simply put, the only backing of the dollar is trust in the government’s policies and confidence in the country’s institutions. The dollar derives its value from the law, which established it as legal tender.
In contrast to commodity-backed currencies like gold or silver coins, fiat currencies have no intrinsic value; their worth is determined solely by how much people trust them at any given time.
What Are the Alternatives to Fiat Currency?
Cryptocurrency is a digital currency that’s not dependent on government control. Cryptocurrencies like Bitcoin allow users to exchange money without relying on institutions like banks or governments.
They also have no physical form (unlike fiat currencies). They can be exchanged freely over the Internet without needing third parties such as PayPal or Visa.
As you know, the dollar is fiat currency because any physical good does not back it. It derives its value from the law, establishing it as legal tender. Herein lies the ultimate problem: Fiat money is a currency with no intrinsic value. It’s not backed by gold or silver and can’t be exchanged for anything else.
In other words, our dollar bill is just paper with some ink on it–it has no real value beyond what people agree to give it. We are now at a point where we’re experiencing hyperinflation due to the excess printing of money.
Our money is not going as far as it should, which will have dire consequences for our economy. I’ll leave you with this final thought: perhaps it’s time to look for alternatives to government fiat money.