What’s fiat currency? In short, fiat currency is an intrinsically valueless object or paper bill that is widely accepted as a means of payment. Generally, fiat currency derives its value from the decisions of central banks rather than from precious metals such as gold or silver.
However, some individuals refer to any money issued by a government and used as legal tender as “fiat currency.” To distinguish fiat currency from cryptocurrency today, the term “fiat currency” is frequently used.
Fiat Currency History
Currency in recent centuries was made of a physical item with an agreed-upon value, most commonly metals such as gold, silver, copper, and bronze. The best example is the British pound sterling, which began as a one-troy pound silver coin. One pound of sterling silver, according to the description. The coin itself held the value of these physical coins.
Governments then began issuing paper currency, or notes redeemable for a measure of the backing standard. Beginning in the 1700s, the answer for the British pound sterling was gold. Until 1933, a single dollar could be redeemed for gold in the United States.
Governments have shifted away from the gold standard over the last century. Currency is now almost universally supported by the governments that issue it. The dollar is an example of fiat money. In 1976, the United States government officially ended the gold-dollar relationship.
What’s Fiat Currency?
Fiat currency is best defined as money that is not backed by a commodity, such as gold or silver. The issuing government usually designates it as such. Local banks and other institutions have occasionally issued fiat currency throughout history. Fiat currency is generally permitted by government regulation in modern times.
In general, fiat currency has no intrinsic value. It has value only because the people who use it as a medium of exchange agree on its worth, trusting that merchants and other people will accept it. Fiat currency is an alternative to commodities, which have intrinsic value because they contain, for example, gold or silver.
Government-issued fiat currency banknotes were first used in China in the 11th century. During the twentieth century, fiat money began to predominate. Since President Richard Nixon’s decision to suspend the US dollar’s convertibility to gold in 1971, the world has relied on a system of national fiat currencies.
Fiat Currency Advantages
Fiat money is a good currency if it can perform the functions that a country’s economy requires of its monetary unit: storing value, providing a numerical account, and facilitating exchange. It also has excellent seigniorage, which means it is less expensive to produce than a currency that is directly linked to a commodity.
Fiat currencies rose to prominence in the twentieth century, in part because governments and central banks sought to protect their economies from the worst effects of the business cycle’s natural booms and busts.
Because fiat money is not a scarce or fixed resource like gold, central banks have far greater control over its supply, allowing them to manage economic variables like credit supply, liquidity, interest rates, and money velocity. For example, the Federal Reserve Bank of the United States has a dual mandate to keep unemployment and inflation low.
Fiat Currency Disadvantages
Because of the limited supply of gold, a currency tied to gold is generally more stable than fiat currency. Because of its unlimited supply, fiat currency provides more opportunities for the creation of several setbacks.
Furthermore, fiat currency can lose significant value if the issuing government or central bank is unable or unwilling to continue guaranteeing its value. Hyperinflation is the usual result. Government budget deficits financed by currency creation have caused almost all hyperinflations.
According to monetarist theories, hyperinflation occurs when there is a rapid increase in the amount of money that is not accompanied by an increase in the output of goods and services.
Most hyperinflations in history occurred after the use of fiat currency became widespread in the late 19th century.
Severe Hyperinflations in World History
|Country||Currency name||Month||Rate (%)||Equivalent daily inflation rate (%)||Time required for prices to double||Highest denomination|
|Hungary||Hungarian pengő||July 1946||4.19×1016||207.19||14.82 hours||100 quintillion P (1020)|
|Zimbabwe||Zimbabwe dollar||November 2008||7.96×1010||98.01||24.35 hours||$100 trillion (1014)|
|Yugoslavia||Yugoslav dinar||January 1994||3.13×108||64.63||1.39 days||500 billion DIN (5×1011)|
|Republika Srpska||Republika Srpska dinar||January 1994||2.97×108||64.35||1.40 days||50 billion DIN (5×1010)|
|Venezuela||Sovereign bolívar||January 2019||2.68×106||40.48||2.09 days||Bs.S 1 million (equivalent to Bs. 1014)|
|Germany||German Papiermark||October 1923||29,500||20.89||3.65 days||100 trillion ℳ (1014)|
|Greece||Greek drachma||October 1944||13,800||17.88||4.21 days||₯100 billion (1011)|
|China||Chinese yuan||April 1949||5,070||14.06||5.27 days||¥6 billion|
|Armenia||Armenian dram and Russian ruble||November 1993||438||5.77||12.36 days||50,000 Rbls|
|Turkmenistan||Turkmenistani manat||November 1993||429||5.71||12.48 days||500m|
How Fiat Currency Works
The phrase “fiat” is a Latin word that means “it shall be” or “let it be done.” Thus, fiat currencies have value only because the government maintains them; fiat money has no utility in and of itself.
Fiat currency arose when governments issued coins made of a valuable physical commodity, such as gold or silver, or printed paper money that could be redeemed for a set amount of a physical commodity. Fiat, on the other hand, is inconvertible and cannot be redeemed because there is no underlying commodity to back it up.
Because fiat money is not linked to physical reserves, such as a national stockpile of gold or silver, it is vulnerable to inflation and, in extreme cases, becomes worthless.
Furthermore, if people lose faith in a country’s currency, the money loses its value. This is not the same as a currency backed by gold, which has intrinsic value due to the demand for gold in jewelry and decoration, as well as in the production of electronic devices, computers, and aerospace vehicles.
Why does Fiat Currency have value?
In contrast to commodity-based money such as gold coins or paper bills redeemable for precious metals, fiat money is entirely backed by the government that issued it. One reason this makes sense is that governments require you to pay taxes in fiat money.
People will accept it in exchange for having to pay taxes or face stiff penalties or prison time. Other money theories, such as the credit theory, contend that because all money is a credit-debt relationship, it makes no difference whether money is backed by anything to maintain value.
Why Fiat Currency is better than Gold
Paper money is thought to have monetary advantages over gold-backed assets. It specifically gives the government good economic control. Furthermore, fiat money is easier to distribute and use in everyday transactions. It is not as heavy as gold coins and can exist in both physical and digital forms.
However, while the relatively simple production process of fiat money makes it a valuable asset for the government, printing too much of it has consequences. Furthermore, the declining value of fiat, as well as some other issues surrounding it, should not be underestimated. Because it is simple to control, other entities may manipulate its circulation, causing economic disruptions.
Fiat Currency vs Crypto
In short, the main difference between fiat currency vs cryptocurrency is that cryptocurrencies don’t require government backing, while fiat currencies depend on it.
Many people are considering cryptocurrencies due to concerns about inflation and government control over money and economic policy. Cryptocurrencies are appealing to anyone who is skeptical of government manipulation of money because they are a decentralized digital asset.
They are also becoming more useful as portable, digital value stores. And, as we’ve seen in recent years as many have skyrocketed in value, they can protect your wealth from inflation.
Most cryptocurrencies are created using blockchain, a cryptographic computer networking technology that allows them to circulate without the need for a central authority like the Federal Reserve.
Many cryptocurrency supporters argue that “decentralization,” in which currencies are governed by users rather than central authorities, will result in more efficient and less corrupt monetary systems.
However, nothing prevents governments from incorporating cryptocurrencies or related technologies into national currency systems. In September 2021, El Salvador became the first country to accept bitcoin as a legal tender. In addition, China is working on a digital version of its national currency, the yuan.
Because most cryptocurrencies are not backed by central banks, their value is derived from a variety of sources. The value of Bitcoin, the first and most valuable cryptocurrency, is generally determined by the market logic of supply and demand. There’s a finite supply of Bitcoin that’s governed by its underlying software, so when demand goes up, so do prices.
Because many cryptocurrency investors speculate on their future value, prices relative to the dollar have been quite volatile. Stablecoins are cryptocurrencies that are currently pegged to the value of fiat currencies.
LEARN MORE: How Stablecoins remain Stable