Fiat money is a currency issued by the government that is not backed by a commodity like gold. Central banks can control the amount of money printed with fiat money, which gives them greater control over the economy. Fiat currencies, such as the US dollar, are the most common paper currencies.
What is fiat money?
Fiat money is a legal tender established by a government. Silver and gold were traditionally used as backing for currency, but the creditworthiness of the government issuing the fiat money determines its value.
It was introduced as an alternative to commodity money and representative money, and is based on supply and demand. Representative money represents a claim to a commodity and is created from precious metals such as gold and silver.
Idea behind fiat money
The word “fiat” comes from Latin and means “it shall be” or “let it be done”. Fiat currencies are valued because the government maintains them. They do not have any utility of their own.
The concept of fiat currency developed when governments struck coins from a valuable physical commodity, such as gold or silver, or printed paper money that could be redeemed for a certain amount of a valuable commodity. Due to the lack of underlying commodity backing Fiat, it cannot be converted or redeemed.
In the event of hyperinflation, fiat money becomes worthless since it does not have any physical backing like gold, silver or national reserves. The rate of inflation can double in a single day in some cases of hyperinflation, such as in Hungary immediately after WWII.
If people lose confidence in a nation’s currency, the currency will no longer be valuable.
The gold standard is different from a currency backed by gold; the gold standard has intrinsic value due to its use in jewellery, decorations, electronics, computers, and aerospace.
Pros and cons of fiat money
Pros
- In contrast to commodity-based money like gold, copper, and silver, fiat money has a stable value.
- Governments and banks adopted fiat money in the 20th century to protect their economies from the frequent bursts of the business cycle. Because of regular business cycles and recessions, commodity-based currencies were volatile.
- Central banks can control the money supply, interest rates, and liquidity to a greater extent.
- Because the Federal Reserve controlled the money supply and demand, it was able to prevent greater damage to the U.S. financial system and the global economy during the Global Financial Crisis of 2008.
Cons
- The Federal Reserve couldn’t prevent the crisis even though it controls the money supply.
- The limited supply of gold, according to those against fiat money, makes it a more stable currency than fiat money, which has an unlimited supply.