Definition
Fiat money is a currency without intrinsic value that has been established as money, often by government regulation. Fiat money does not have use value, and has value only because a government maintains its value, or because parties engaging in exchange agree on its value. It was introduced as an alternative to commodity money and representative money. Commodity money is created from a good, often a precious metal such as gold or silver, which has uses other than as a medium of exchange. Representative money is similar to fiat money, but it represents a claim on a commodity.
Fiat Money
Fiat money is a currency without an intrinsic value that has been declared as a legal tender by the government. Its value is derived by studying the relationship between demand and supply, instead of taking into account the value of the material that makes up the currency.
In the ancient times, the currencies were in fact based on physical commodities as people used silver, bronze, and gold. Fiat money works differently and is based on faith, which is not surprising since the word fiat means “it shall be” in Latin.
Learning about Fiat Money
The risks with fiat are very low due to hyperinflation since the money is not linked to any physical reserves. As mentioned above, the only reason why the currency has value is because of faith. If people stop trusting the Dollar or the Euro, the money will not have any value.
All the currencies in today’s world are fiat money because they are only used to make payments and have no intrinsic value, whatsoever. It is only used as a mode of payment, and is inconvertible. Fiat money rose to popularity in the 20th century, after the disintegration of the Bretton Woods system, when the United States of America stopped converting dollars into gold.
How Fiat Money Works
Fiat money is a valid form of payment due to the virtue of the government. It allows the government to use any material (paper in this case) to use as a mode of payment. Since fiat money has no intrinsic value, its conceived value can diminish that can lead to hyperinflation.
The central banks and markets study the value of the paper according to how a country is working, its economy’s state and how these two factors will affect the interest rates.
Fiat money is the exact opposite of commodity money as the latter is valuable and has an intrinsic value. Commodity money was used earlier on and included grains, furs, and valuable metals like gold, silver, and bronze.
Importance of Fiat Money
Other than the apparent convenience and universality of real-life transactions, fiat money is an economical and stable way of running and regulating cash flow from an individual level to a government level.
Further Reading
- A theory of money and financial institutions: Fiat money and noncooperative equilibrium in a closed economy – link.springer.com [PDF]
- Part I: Seigniorage of fiat money and the maqasid al‐Shari'ah: the unattainableness of the maqasid – www.emerald.com [PDF]
- Credit money, fiat money and currency pyramids: Reflections on the financial crisis and sovereign debt – link.springer.com [PDF]
- Seigniorage of fiat money and the Maqasid al‐Shari'ah – www.emerald.com [PDF]
- Money, prices and finance in the new monetary economics – www.jstor.org [PDF]
- Are alternative currencies a substitute or a complement to fiat money? Evidence from cross-country data – research.tilburguniversity.edu [PDF]
- The optimal bankruptcy rule in a trading economy using fiat money – link.springer.com [PDF]
- Bitcoin–its economics for financial reporting – onlinelibrary.wiley.com [PDF]
