Fiat Money Definition (Characteristics and 3 Examples) - BoyceWire
Fiat Money Definition

Fiat Money Definition

Fiat Money Definition
Characteristics, Examples, and Advantages

WRITTEN BY PAUL BOYCE | Updated 12 September 2020

What is Fiat Money

Fiat money is a currency without an underlying value. Instead, its value is derived by government and the trust people place in its value. In other words, it is a form of currency that only holds value because of government enforcement.

On its own, ‘fiat’ is defined as ‘a formal authorization or proposition; a decree.’ Simply put, fiat money is a type of money that is given value purely by an official law or order. At the same time, the true value lies in the trust that people place in it. If consumers and businesses didn’t trust in it as a store of value, then it would not be accepted as a medium of exchange. It is only because people believe others will accept it in exchange for goods that it maintains its value.

Key Points
  1. Fiat money is a type of currency which derives its value through government decree and the public’s trust in it.
  2. Once the public loses its trust in fiat money, the economy is significantly affected. For instance the overproduction of fiat currency in the Weimar Republic contributed to hyper-inflation, with parts of the public using it as wallpaper instead.
  3. The supply of fiat money is generally controlled by central banks – but was historically under the power of the domestic government.

Whilst much of its value is granted by the government, fiat money would be worthless if consumers do not trust it. For instance, a number of African governments such as Zimbabwe have been known to print an excessive amount of money, thereby creating hyperinflation. The economy is flooded with new money, thereby deflating its true value. What this does is erode people’s trust in the government’s ability to maintain its value.

This can encourage excessive levels of consumption as consumers don’t want to keep hold of cash for long in case it loses value. What this does is harm economic growth as it shifts capital away from savings and investment, and towards immediate consumption.


Characteristics of Fiat Money

1. No Intrinsic Value

Fiat money has no intrinsic value, which is in contrast to commodity money – where value comes from the underlying commodity. For instance, gold has other uses other than money and therefore, has an intrinsic value. However, fiat money has only one use and one use only – to act as a currency.

2. Value linked to Trust

Commodity money has an underlying value, so the average consumer knows that even if Mr A doesn’t accept it, then Mr B will. For instance, gold has historically held significant value due to its rarity – which is seen as a status symbol of power and wealth. By contrast, however, fiat money derives its value through people’s trust in its value and willingness to accept it.

If consumers did not have confidence in the fact that other people would accept it, the currency would have no value. If the average consumer knew Walmart would accept the currency, there would be a level of trust placed in it. However, fiat money falls apart when people start to refuse it as a medium of exchange. As it is legal tender, it means businesses such as Walmart have to accept it and therefore, enshrines peoples trust in it.

3. Backed by Government

Fiat money is only a fiat money if it is backed by government. Without government approval, it is not ‘fiat’ – which is defined as formal authorisation. In other words, it is ‘legal tender’. This could also be applied to other forms of money that government chooses to use. However, with fiat money, it is a defining trait as this is the main source of its value.

Businesses are legally required to accept the fiat currency, which helps establish consumers trust in its value. This is because consumers can trust the fact that they can go to their nearest store and exchange it for goods and services.

4. Unlimited Supply

Technically, the supply of fiat money is endless. Central banks can ‘print’ an almost infinite amount – perhaps only being restricted by the amount of paper it requires. For instance, we only need to look at Venezuela as an example. Its currency, the Bolivar Fuerte, replaced the original Bolivar, but inflation is still in the thousands. This is because there are no clear restrictions on how much the government can or cannot print.


Fiat Money Examples

In todays day and age, fiat money is everywhere in almost every country. There is a minor exception in the form of Lebanon which operates a form of the gold standard. Nevertheless, every other nation operates on some form of fiat money. Some examples include:

Euro

The Euro is controlled by the European Central Bank (ECB) and is the official currency of 19 countries within the European Union. We can consider the Euro as fiat money because it is not exchangeable for anything other than the value of goods. In other words, it has no value other than its use as a medium of exchange.

US Dollar

The Federal Reserve controls the supply of the US dollar and is the official currency of all 50 US states. Whilst the US dollar has been around for centuries, it only recently became a fiat money. Up until 1971, the US dollar could be readily exchanged for gold. President Nixon subsequently cut these ties in August 1971, in what was to become known as the ‘Nixon Shock’.

What happened after was the US dollar floated freely on the exchange market and became a fiat currency. In turn, the monetary system of the world changed, with many other nations following suit.

Great British Pound

The Central Bank of England controls the supply of the Great British Pound (GBP) and is the currency of all four nations in the British Isles: England, Wales, Scotland, and Northern Ireland. The UK abandoned the gold standard in 1931, yet was not a fiat currency as it still had ties to gold.

Although the UK cut its ties to gold, it was still intrinsically linked to it through the Bretton Woods agreement of 1944. Rather than being backed by gold, it was backed by the US dollar, which in turn, was backed by gold. The reason being was that the US had the largest gold reserves in the world and was on its way to becoming a global superpower. So the control of gold was essentially centralised in the US.

At the same time, the exchange rates between the US dollar and the Great British Pound were fixed, so essentially it was still backed by gold in all but name. Similarly, this came to an end alongside the ‘Nixon Shock’ which ended the US and consequently the UK’s indirect tie to gold.


Fiat Money vs Representative Money

It is very easy to get confused between fiat and representative money. Both can be paper money such as the US dollar, and both have no value in and of itself. However, there is a key difference between the two.



Representative money can be exchanged for a commodity such as gold or silver. If we look at the Bretton Woods agreement before 1971, this is exactly what the US dollar did. It allowed people to trade $35 for one ounce of gold. So although the average US citizen traded pieces of paper in the form of the US dollar, it could at any time be redeemed for gold at the bank.

So representative money is similar to fiat money in that it is generally made of paper, but it represents a quantity of a commodity. By contrast, fiat money represents the value that people believe it is worth. In other words, how many goods or services does the consumer think $10 can buy.


Advantages of Fiat Money

As the world is operating under a fiat currency, there must be some logical explanation of why we trade fiat money, which is essentially, worth pieces of paper? Let us look at some of the reasons why below:

1. Supply is Unlimited

Central Banks can produce as much money as they like and with the advancement of technology, they don’t even have to print it anymore. This is both an advantage, and, if not controlled properly, a disadvantage. However, let’s focus on it as an advantage.

The Central bank can produce Fiat money in any quantity. By contrast, gold, silver, or any other commodity is firstly limited by the number of laborers available to mine. And secondly, the limited nature of its existence.

If we look at what money essentially is; it represents the value of goods in the economy. So when money is traded, it represents the labor that went into it, as well as the value the consumer places in it. In turn, the amount of money in circulation has to increase alongside GDP and the number of goods and services in the economy.

If we look back to the Great Depression in 1929, the cause was linked to the decreasing supply of the US dollar when compared to the United States’ economic growth. At the time, the US dollar was linked to gold, which partly explains why the Federal Reserve was reluctant to print more dollars. It was representative money, so if it printed too much, there wouldn’t be enough gold to satisfy demand, particularly if there was a run on the banks.

This reluctance to print more money meant the money in circulation represented more and more goods each year. For instance, in a basic example economy, there is $1 million in circulation and 1,000 cars are made which represent this. That works out at $1,000 per car. However, in five years’ time, there is still $1 million in circulation, but 2,000 cars are now made. As a result, prices adapt to represent the amount of money in circulation. So the price of cars declines to $500.

This has its own effect on the wider economy, but the restrictive nature of commodity or even representative money can mean its supply is unable to match economic output. As a result, this provides fiat money with an advantage.

2. Cheaper to Produce

Commodity money and representative money both require the extraction of a commodity. Whether it is gold, silver, or something else, it requires labor to extract it. This alone provides a huge and arguably unnecessary cost.

So you need someone to mine it, transport it, mould it where necessary, and then finally store it. All in all, it adds an extortionate cost to maintain its supply. By contrast, the cost of fiat money is almost nil. Whilst there is the cost of production for the paper, much of the transactions are being done online. So the need for that is also declining.

3 Stability

Fiat money brings stability, partially because of the previously mentioned advantages. As the money supply can react to increasing economic output, it is able to represent the goods available much more effectively. It is cheaper and easier to produce, so it can enter the market in a short period of time.

In addition, there are other factors to consider. For example, in times of crisis, people tend to hoard commodities such as gold or silver. Similarly, currencies that are back by such are more likely to face a run on the banks. The Depression of 1929 is a classic example.

What fiat money does is cut ties with commodity money and therefore reduce demand for such commodities. This creates a greater level of price stability as consumers are not so prone to store it.

For instance, the 2008 Financial Crisis was the worst economic recession since 1929. Yet, at the same time, prices remained relatively stable. In the US, inflation never reached more than 4 percent, nor did it fall below -1 percent. Quite extraordinary considering the scale of the economic crisis.

If we look back at 1929, when the US was on the gold standard, inflation declined by a cumulative total of over 28 percent in the three subsequent years. However, it must be said that the stability is largely reliant on the decisions made by the Central Banks, which can have more of an effect than the type of currency used.


General FAQs on Fiat Money

What is Fiat Money example?

Fiat money is used in virtually every country in the world. For example the US dollar is a fiat currency. This is because it is declared legal tender by the government as is not backed by a commodity.

Why is it called fiat money?

‘Fiat’ is defined as ‘a formal authorization or proposition; a decree.’ In turn, fiat money is essentially money that is authororised by government decree.

What are the advantages of fiat money?

One of the main advantages of fiat money is that the supply can be increased at any point to meet the demand of the economy.

Second of all, fiat money costs but a fraction to maintain when compared to other forms of money that rely on a commodity.

Third of all, it is relatively stable. At least under a compontent Central Banking system.




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