Fiat Money

Refers to the money which is used every day by people across the globe in transactions, wages, investing, and consumption

Author: Jackson Hartz
Jackson Hartz
Jackson Hartz
Jackson Hartz is a fourth-year Economics major at the University of California, Los Angeles (UCLA). Hartz is also the author of “Building Your Financial Future: A Practical Guide for Young Adults” which was featured as a #1 hot new release in Amazon Personal Money Management books. He has been published in the California Business Journal and is the founder of the Financial Literacy Group at UCLA.
Reviewed By: Adin Lykken
Adin Lykken
Adin Lykken
Consulting | Private Equity

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The Boston Consulting Group as an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

Last Updated:October 3, 2023

What is a Fiat Money?

Cash, coins, and even the money in your checking account do not have intrinsic value. In other words, the physical money or numbers on the screen of your checking account do not have any intrinsic value. Instead, they derive their value from the government.

Fiat money is used daily by people across the globe in transactions, wages, investing, and consumption. The most commonly used bill worldwide is the U.S. Dollar.

Traditionally currencies were backed by commodities such as silver or gold. However, around 1000 AD, China implemented the first instance of paper money due to the exceedingly high demand for precious metals.

The concept of using paper money was easily adapted in China because its citizens were accustomed to using credit notes. As a result, the use of such money surged in the Yuan and Ming dynasties.

In the 18th century, the West began using money not backed by a commodity. Bills of credit were issued that holders could use to make payments. The lack of regulation of bill production led to fear of inflation, and in some regions, the bills depreciated significantly.

The U.S. gold standard allowed paper money to be converted into a fixed amount of gold.

This was the basis for the international monetary system from the 1870s to 1932 and from 1944 until 1971, when the system was abandoned to prevent inflation and avoid significant payouts from foreign entities cashing in their U.S. dollars for gold.

Understanding Fiat Money Currency

What does the term “fiat” mean? Fiat is a Latin word for “let it be done.” These bills only have value because the government says they do. Intrinsically, there is no utility to money not reinforced by a commodity.

Traditionally, money could be converted to gold or another commodity, but now money is not directly linked to any physical reserves. As a result, modern economies are susceptible to inflation and hyperinflation.

Nowadays, money only has value as long as people have faith in it. Once the majority of people lose trust in the local currency or the governmental regulation of it, the value will plunge.

Fiat money can be:

  • Any money not backed by a commodity

  • Money declared to be legal tender by a government or institution

  • Legal tender accepted as payment for a debt

  • A non-valuable object that serves as a medium of exchange (also known as fiduciary money)

value of fiat money

Money derives its value from the government that issues it. A reliable government regulating its cash production is more likely to have a stable currency. 

Taxes must be paid with the local currency the government issues. As a result, to avoid penalties or prosecution, citizens accept the value of money to pay taxes.

Credit theory also proposes that the exchange of a commodity for credit springs from the idea that credit value does not depend on precious metals or other commodities.

The arbitrary nature of money is evident in that prices can change at any moment. For example, if the demand skyrockets for goods, the price will also increase.

Advantages and Disadvantages of Fiat Currency

Some of the advantages are:

  • It has excellent seigniorage, or the difference between the production costs and the value of coins is significant. In other words, money is cost-efficient to mint. 

  • Can handle the necessary functions required of a monetary unit, such as providing a store of value and a numerical account along with facilitating exchange.

  • It allows for ease of regulation and control over the supply. This authority over money supply allows central banks and governments to manage variables such as credit supply, interest rates, and money velocity.

  • Since there is more control over the money supply, recessions can be managed to minimize economic devastation. This contrasts with the volatility experienced when money was commodity-based.

The disadvantages include:

  • The supply is unlimited, which makes it less stable. As there was a limited supply of gold, the value of money backed by this precious metal was able to hold its value. Since there is no backing, inflation is more likely.

  • It does not provide a foolproof way to protect the economy from recessions and economic collapse

  • Some would argue the government has too much authority and that, in the wrong hands, this can lead to disaster. For example, hyperinflation can occur with poor money supply management, making a currency worthless.

modern economies and fiat money

The modern economy would not be able to sustain a commodity-backed currency as a result of diminished natural gold and silver sources. This would cause significant disruptions to the market.

With the abandonment of the gold standard, resource holdings could be decreased, which made the exchange of money far more accessible.

Today, governments have more flexibility to manage their currency, stabilize global markets, mitigate recessions, and set monetary policy.

Governments around the world also have the ability to create their currency because it does not require an abundance of a commodity to support it. 

Fractional reserve banking would also not be possible without money unbacked by a commodity. This system allows commercial banks to lend money to borrowers and boost the economy. 

The modern world is beginning to distance itself from using cash and bills and is moving towards payments through technological services. This includes peer-to-peer (P2P) services, credit cards, and bank services.

Money creation and regulation

Banks play a crucial role in the distribution and creation of money. A central bank increases the money supply by trading financial assets and lending money to financial institutions. The money issued by central banks is called base money.

Commercial banks use the money they receive from the central bank to distribute loans through a system called fractional reserve banking. This system allows banks to loan out all money that is not required to keep as reserves to distribute as withdrawals.

Physical money makes up only a small minority of the total money supply. For example, in 2010, in the U.S., only 10% of the total money supply consisted of physical cash and coins.​​

The United States Mint carries out the production of physical bills and coins in the United States. The Bureau of Engraving and Printing (BEP) is the government agency within the United States Department of the Treasury that designs and produces physical currency.

There are various types of money in the total money supply of a country. For example, the United States has M1, M2, and M3 levels. These are determined by the liquidity and size of the money supply in the economy.

For example, M1 includes physical coins and bills but also other money equivalents. These are examples of very liquid cash.

M2 includes short-term deposits in banks and certain money market funds. These assets are slightly less liquid than those in M1.

Examples of Fiat Money

There are hundreds of examples of fiat money today, but here are the currencies that dominate the global economic scene:

The United States Dollar is the strongest currency in the world because it is supported by a powerful economy and a large GDP. The European euro originated in Germany but is now used in 19 countries.

To be considered fiat currency, it must be physical, like coins and paper bills. 

Here is a list of the currencies in circulation today.

fiat currencies worldwide

There are about 180 currencies worldwide. For the first time in history, every currency used today is fiat. A commodity backs no currencies.

Some currencies, like the U.S. dollar, have been used since birth. On the other hand, some currencies, like the Zimbabwean dollar, have been replaced as a result of hyperinflation.

The world is able to function with all these currencies by utilizing exchange rates. An exchange rate values one country’s currency in terms of another one. These exchange rates are subject to change due to supply and demand.

Domestic interest rates can also cause exchange rates to fluctuate. With some research, traders can try to jump at the opportunity of buying currencies in hopes that the exchange rates will change in their favor.

The most popular currencies for trading are:

  • U.S. Dollar

  • Euro

  • Japanese Yen

  • Great British Pound

  • Australian Dollar

  • Canadian Dollar

Non-fiat Money

While fiat money only consists of physical money, the non-fiat currency is considered representative money. Representative money is a form of currency representing the intent to pay, such as credit. 

Some entities must back representative money. Otherwise, the money is worthless. Representative money also has no intrinsic value.

Examples of representative money:

  • Checks

  • Credit Cards

  • Bills of Credit

  • Silver and Gold Certificates

  • IOU Notes

Fiat Money FAQs

Researched and authored by Jackson Hartz | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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