Money is a sine qua non of any financial transaction and a collectively accepted representation of value. Throughout history, money has taken many forms. For instance, some of the earliest forms of money were from precious metals such as silver and gold. In today’s world, fiat money — government-issued legal tender — is the most common form of money.
What Is Fiat Money?
Fiat currency is a currency established as a valid form of money, usually backed by a government. The term “fiat” is derived from Latin and describes a government decree, order, or regulation. By definition, fiat money has no intrinsic value because a physical commodity does not back it.
Until the 20th century, most countries used the gold standard or commodity supply. However, as international trade and finance grew, the limited amount of gold from mines and central bank vaults could not keep up with new value creation, causing disruptions in global financial markets. Nowadays, fiat money is usually made from worthless or low-value material, such as a small piece of paper. Despite this, fiat money is widely used as a means of payment.
The value of fiat assets is based on supply and demand and the stability of the issuing government. In addition, the value of fiat money depends heavily on the collective agreement that it has market value and can be used as a medium of exchange with domestic purchasing power. Thus, the acceptance of fiat money is highly dependent on the belief that it will retain its value in the future. Many world currencies are fiat currencies, including the dollar and euro.
Fiat money gives central banks more control over an economy because central banks can directly control how much money is printed. Fiat currencies have no inherent value; only governments maintain that value. Since physical reserves do not back fiat money, it risks losing value due to inflation. In the worst case of hyperinflation, the inflation rate can double in a single day, such as in Hungary shortly after World War II.
History of Fiat Money in the USA
The U.S. dollar is fiat money and legal tender accepted in payment of private and public debts. Legal tender is any currency declared by a government to be legal for paying debts and obligations. Governments create legal tender by establishing the national currency as the standard for debt repayment.
Previously, the value of U.S. currency was pegged to the price of gold. Following the passage of the Emergency Banking Act of 1933, the federal government no longer allowed citizens to exchange their currency for government gold. The gold standard, which backed U.S. currency with federal gold, was completely abolished in 1971 when the U.S. stopped issuing gold to foreign governments in exchange for their currency. Since that time, the U.S. dollar has been backed by “full faith and credit.” The U.S. dollar is now “legal tender” but not “lawful money” that can be exchanged for gold, silver, or any other commodity.
Advantages of Fiat Money
Fiat money is used by world economics as a store of value, a numerical account, and ease of exchange. It also provides excellent seigniorage, meaning it is cheaper for the government to produce than a currency tied to the price of a commodity. Fiat money gives governments more flexibility to manage their own currencies, set monetary policy, and stabilize global markets. It also enables fractional reserve banking, allowing commercial banks to multiply the amount of cash they hold to meet borrowers’ demands.
Governments and central banks use fiat currencies to protect their economies from the effects of the ups and downs of the business cycle. Fiat money, unlike gold, is not a scarce resource. Thus, central banks can control the supply and demand of it. This allows them to control economic variables such as credit supply, liquidity, interest rates, and the velocity of money in circulation. For example, the Federal Reserve is required by law to keep unemployment and inflation low.
Disadvantages of Fiat Money
The subprime crisis of 2007 and the subsequent financial crash demonstrated that central banks cannot always prevent depressions or severe recessions by regulating the money supply. For example, a currency pegged to gold is usually more stable than fiat money because of the limited supply of gold. On the other hand, there are more opportunities to create bubbles with fiat money because of the unlimited supply.
The African country of Zimbabwe became an example of the worst-case scenario in the early 2000s. In response to severe economic problems, the Central Bank of Zimbabwe began printing money at a dizzying pace, resulting in hyperinflation. It is believed that the currency lost 99.9% of its value during this time. Since prices rose rapidly, people were required to carry bags full of money to buy food. The Zimbabwean government was even forced to issue a $100 trillion bill.
Fiat money is evolving
Paper money has been criticized for having no intrinsic value, gaining value only through its status as legal tender. Our monetary system is based on central authorities’ monetary and fiscal policy decisions, i.e., governments and central banks. However, as history shows, money has evolved.
The emergence of cryptocurrencies built on blockchain technology represents a fundamental renewal of the world’s money system. Over the past decade, cryptocurrencies like Bitcoin have challenged the inflationary nature of fiat currencies. While fiat currencies are still the predominant form of money, cryptocurrencies and their underlying blockchain technology can represent the next step in the money evolution. Digital currencies built on decentralized blockchain networks can offer significant opportunities for financial inclusion worldwide.
Both cryptocurrencies and fiat currencies can be purchased on exchanges and held as investments, traded for other assets, or exchanged and spent in exchange for goods and services. However, cryptocurrency derives its value from the blockchain, where monetary policy is transparent and written into the code base of the protocol. Although cryptocurrencies do not have financial policies in the economic sense, their monetary policies are governed by the governance and consensus mechanisms of the protocol.
Unlike fiat currencies like the U.S. dollar, cryptocurrencies are untraceable and function independently of any government. The most famous example, Bitcoin, emerged in 2009 during the financial crisis amid concerns about the global financial system’s stability. Its proliferation was largely fueled by fears of political instability and concerns about excessive government debt. There are currently nearly five thousand cryptocurrencies on the market, worth over $3 trillion. Bitcoin and other cryptocurrencies are at the forefront of the digital revolution in the global financial system.
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