FIAT MONEY
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DiFIAT MONEY
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DiFiat Money
Money with no intrinsic value but made legal tender by a government order
What is Fiat Money?
Fiat money is a currency that lacks intrinsic value and is established as a legal tender by government
regulation. Traditionally, currencies were backed by physical commodities such as silver and gold, but
fiat money is based on the creditworthiness of the issuing government.
The value of fiat money depends on supply and demand and was introduced as an alternative to
commodity money and representative money. Commodity money is created from precious metals such as
gold and silver, while representative money represents a claim on a commodity that can be redeemed.
China was the first country to use fiat currency, around 1000 AD, and the currency then spread to
other countries in the world. It became popular in the 20th century when U.S. President Richard
Nixon introduced a law that canceled, the direct convertibility of the U.S. dollar into gold. Currently,
most nations use paper-based fiat currencies that only serve as a mode of payment.
Unlike the traditional commodity-backed currencies, fiat currency cannot be converted or redeemed. It
is intrinsically valueless and used by government decree. For a fiat currency to be successful, the
government must protect it against counterfeiting and manage the money supply responsibly.
History of Fiat Money
Fiat money originated from China in the 10th century, mainly in the Yuan, Tang, Song, and Ming
dynasties. In the Tang Dynasty (618-907), there was a high demand for metallic currency that
exceeded the supply of precious metals. The people were familiar with the use of credit notes, and
they readily accepted pieces of paper or paper drafts.
A shortage of coins forced people to change from coins to notes. During the Song Dynasty (960-1276),
there was a booming business in the Sichuan region that led to a shortage of copper money. Traders
started issuing private notes covered by a monetary reserve, and it was considered to be the first
legal tender. Paper money became the only legal tender in the Yuan Dynasty (1276-1367), and issuing
of notes was conferred to the Ministry of Finance during the Ming Dynasty (1368-1644).
The West started using paper money in the 18th century. American colonies, France, and the
Continental Congress started issuing bills of credit that were used to make payments. The provincial
governments issued notes that the holders would use to pay taxes to the authorities. The issuing of
too many bills of credit generated some controversy due to the dangers of inflation.
In some regions, such as New England and the Carolinas, the bills depreciated significantly and there
was a hike in commodity prices as the bills lost value. During wars, countries turn to fiat currencies to
preserve the value of precious metals such as gold and silver. For example, the Federal Government of
the United States turned to a form of fiat currency referred to as “Greenbacks” during the American
Civil War. The government halted the convertibility of its paper money to gold or silver during this war.
In the early 20th century, the government and banks had promised to allow the conversion of notes
and coins into their nominal commodity on demand. However, the high cost of the American Civil War
and the need to rebuild the economy forced the government to cancel the redemption.
The Bretton Woods Agreement fixed the value of one troy ounce of gold to 35 United States Dollars.
However, in 1971, United States President, Richard Nixon, introduced a series of economic measures
including canceling the direct convertibility of dollars into gold due to declining gold reserves. Since then,
most countries have adopted fiat monies that are exchangeable between major currencies.
How Does Fiat Money Work?
Fiat currency is not supported by any physical commodity, but by the faith of its holders and virtue of
a government declaration. Paper money acts as a storage medium for purchasing power and an
alternative to the barter system. It allows people to buy products and services as they need without
having to trade product for product, as was the case with barter trade.
Due to its ability to store purchasing power, people can make plans with ease and create specialized
economic activities. For example, a business dealing with mobile phone assembly can buy new equipment,
hire and pay employees, and expand into other regions.
The value of fiat money is dependent on how a country’s economy is performing, how the country is
governing itself, and the effects of these factors on interest rates. A country experiencing political
instability is likely to have a weakened currency and inflated commodity prices, making it hard for
people to buy products as they may need.
A fiat currency functions well when the public has enough confidence in the currency’s ability to act as a
storage medium for purchasing power. Also, it must be backed by the full credit of the government
that gives a decree and prints it as a legal tender for financial transactions.
Advantages and Disadvantages of Fiat Currency
The most important feature of fiat money is the stability of its value, unlike commodity-based money
like gold, copper, and silver. The use of fiat money became popular in the 20th century as governments
and banks moved in to protect their economies from the frequent busts of the business cycle.
Commodity-based currencies were volatile due to the regular business cycle and periodic recessions. The
central banks can print or hold paper money as they may need, giving them greater control over the
money supply, interest rates, and liquidity. For example, the Federal Reserve’s control over the money
supply and demand enabled it to manage the Global Financial Crisis of 2008 from causing greater
harm to the U.S. financial system and global economy.
Although fiat money is viewed as a more stable currency that can cushion against recessions, the
global financial crisis proved otherwise. Even though the Federal Reserve controls the money supply, it
was not able to prevent the crisis from happening. Critics of fiat money argue that the limited supply
of gold makes it a more stable currency than fiat money, which has an unlimited supply.
