What Is Fiat Money?
Fiat Money Explained in Less Than 5 Minutes
BY MIKE PRICE
Published November 03, 2021
Fiat money is a currency that is backed by nothing except the faith and credit of the government issuing it. Basically every usable currency around the world today is a fiat currency. The U.S. dollar has been fiat since 1971.
Doing business with fiat money is just a fact of life. Let’s talk about how fiat money works and then discuss the alternatives.
Definition and Examples of Fiat Money
Fiat money is a currency that is declared money by decree—not by the marketplace. Though some fiat currencies were once backed by commodities, they are now only backed by the legislative power of the government issuing them.
The U.S. dollar was originally on the gold standard, which means all dollars could be traded for gold but is now a fiat currency. Franklin Roosevelt severed the gold standard for Americans in 1933, to be able to inflate the currency and attempt to stimulate the economy during the Great Depression.1
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The dollar was then on a semi-gold standard until the so-called Nixon Shock in 1971 when Richard Nixon ended the convertibility of the dollar into gold by foreign countries as well.2
Governments that create a fiat currency can change the amount of currency in circulation to try and manage the economy.3
How Fiat Money Works
Let’s use the dollar as an example of how fiat money works. The Federal Reserve was originally created to save banks from panics (where more dollars in deposits are redeemed than the bank has in its vaults) but has since evolved into a bigger position managing the economy.
The Federal Reserve manages the supply of dollars. It was given a dual mandate by the government to reduce unemployment and keep inflation at a steady level. It does this by:
- Increasing the amount of Treasurys it buys from private dealers (buying them with new dollars that it creates)
- Reducing the interest rate it pays to banks for reserves deposited at the Federal Reserve (encouraging banks to lend)
- Reducing the amount of money banks are required to keep as reserves.4
While fiat currency doesn’t have an intrinsic value, as a commodity currency does, some economists argue that the currency does have value because governments require taxes to be paid in the currency. Legal tender laws can also give a fiat currency value—if it is the only currency that can be accepted legally for transactions, it will have some sort of value.56
Fiat money, like commodities, is valued based on supply and demand. Excessive supply of a fiat currency will lead to a drop in its value. When the value of money drops, prices go up (inflation). History is full of examples, such as Weimar, Germany, in the 1920s, and, more recently, Zimbabwe and Venezuela, of governments increasing the supply of fiat money too much and causing hyperinflation.
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The purchasing power of the U.S. dollar has declined signifcantly since the Federal Reserve was created in 1913. Today you can purchase only 3.5% of what you could do back then with one dollar.7
Alternatives to Fiat Money
Proponents of the gold standard argue that the finite supply of gold sets a limit on the amount that the government can inflate the currency. The government wouldn’t be able to inflate the currency without bringing in more gold for people who redeemed the currency for it.
The argument against the gold standard is that the limit of currency expansion is artificial and can cause deflation. Deflation sounds great for consumers because it lowers prices on consumer goods, but it can hurt consumers because it can cause companies to cut down their labor force to make up for lost revenue from those lower prices.
Cryptocurrencies—Bitcoin, for example—are not as manipulable by governments. It’s unlikely that world governments will ever go back to a gold standard after leaving it en masse in the 20th century, so the only way to move away from fiat currency may be with a market takeover by Bitcoin.8
The problem is volatility. Over the past several five years Bitcoin’s value has increased from less than $800 to, at multiple points in 2021, more than $60,000, while at the same time seeing steep price decreases of more than $30,000 in just a few months. Big gains and drops in less than a year won’t work for a nation’s currency, which has to be more stable.9
Key Takeaways
- Fiat money is money that is declared money by government decree, not through a market process.
- Fiat money has value because government taxes are paid by it and it is made legal tender for business transactions.
- The gold standard and Bitcoin are potential alternatives to fiat money that likely wouldn’t lead to as much inflation.
Source: The Balance
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