What is fiat money? How it works with examples
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Have you heard the term ‘fiat money’ but aren’t sure what it means? Perhaps you want to learn the difference between fiat currency and commodity currency?
You’ve come to the right place. In this guide, we’re taking a close look at fiat money to show you how it works, how its value is decided, and how it compares to other forms of currency. Use the links below to navigate or read on for the complete guide.
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What is Fiat Money?
Fiat money is any currency that lacks actual value. Instead, it’s a legal tender issued and backed by world governments.
Historically, the value of currency was backed by physical commodities, such as gold and silver.
It may surprise you to learn that the money in your wallet is intrinsically valueless. It can’t be converted or redeemed into anything tangible and is instead purely used as a mode of payment.
Fiat money relies on tight fiscal control by regulatory bodies, which allow its use in specific territories by government decree. For this reason, it’s vital that fiat money is managed responsibly and ethically, with efforts made to reduce counterfeiting and mismanagement.
The concept of fiat money might sound modern, but it’s been around since at least 1000 AD, when it was first introduced in China. It didn’t, however, become prevalent in the Western World until the 20th century, when countries such as the UK and US began converting the pound and the dollar into fiat-based currency systems.
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How Does Fiat Money Work?
As touched on above, fiat money isn’t backed by commodities like precious metals. Its value instead comes from the faith people have in it and the government tasked with regulating it.
One of the key reasons fiat money was introduced in the first place was to increase the liquidity of day-to-day currencies. Modern paper money is designed to offer a simple, flexible way for people to buy and sell goods, without the need for complex trade negotiations.
What’s more, the nature of fiat money allows for greater buying confidence and monetary freedom. For example, if a business wants to expand its operations by investing heavily, fiat money allows for this without the need for physical commodities to be exchanged – helping to accelerate economic and societal growth.
So, how is the value of fiat money controlled and regulated? Because it’s not reliant on a set commodity amount, other factors come into play to decide its value, including interest rates, inflation, and economic performance. Even things like political instability can affect the value of fiat money, which is why people continue to invest in commodities like gold.
In short, fiat money only works if consumers have confidence in it. This relies on responsible management by standing governments, who must also demonstrate creditworthiness and tight regulatory control.
What Are the Pros and Cons of Fiat Money?
Fiat money is now the prevalent form of capital throughout the world. But why is it used? And what are its strengths and weaknesses?
Let’s take a closer look at the pros and cons of fiat money.
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Pros
One of fiat money’s key strengths is it’s an asset that’s easy to control and predict – which is crucial in avoiding economic shocks, such as recession.
Remember: governments themselves control fiat money, which gives them more breathing room in terms of supply and value than other forms of currency. Though care is needed, central banks have the power to create more money when market conditions require it, which can help to cushion the economy against periodic fluctuations.
For example, following the 2008 financial crash, fiat money was used strategically to lessen the impact on the US financial system. How?
Cons
Naturally, as with any form of currency, fiat money has its disadvantages, chief among which being the very essence of its value. Those critical of fiat money and successive governments’ reliance on it question how it will maintain its value in the long term, particularly as more cash is brought into circulation.
Unlike commodities, fiat money is backed by nothing other than its perceived value. But what happens when too much money is brought into the economy, and denominations cease to hold the value they once did?
Critics of fiat money suggest that its value cannot be guaranteed in the future. This is in direct contrast to commodity-based money, for which there is a supply of precious metals and other assets that offer the potential for long-term value.
Remember, too, that the supply of fiat money is seemingly unlimited, while reserves of commodities such as gold and other alternatives like cryptocurrencies, are limited. This suggests that commodities are ultimately more stable in the longer term.
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Fiat Money Examples
Fiat money has risen to become the world’s most prevalent form of money, and very few global currencies are now true commodity-based currencies. Well-known examples of fiat money include the US dollar, pound sterling, and the euro, with the US, UK and all European nations operating on a fiat-based currency system.
It’s important to note, however, that many countries use a combination of currencies, including fiat and commodity money. This is to offer the best line of defense against economic shock, while maintaining the right level of value and monetary demand.
Why Do Governments Use Fiat Money?
By now you should have a reasonable grasp of the role, advantages, and pitfalls of fiat money. But why exactly has the currency come to dominate the global economic landscape, with most world governments relying on it as a principal form of currency?
Managed correctly, and fiat money serves as a powerful resource for governments, allowing for predictable and tight control of current economic conditions. If it’s utilized responsibly, it provides the very best means of fulfilling the roles of a strong economy, including storing value, providing a means of numerical accounting, and facilitating streamlined exchange.
Most of the problems associated with fiat money arise from improper management and use. For example, if a government prints too much money, quantitative easing, this can lead to hyperinflation, which can be hugely economically damaging in the long term.
For individuals looking to save money and store it somewhere safe, the fiat system may not offer the most secure or profitable conditions. That’s why we’re seeing a rise in currency alternatives – with gold chief among them.
We hope this guide has shed light on how fiat currency works and what it means for your money. If you’re looking for a safe, secure, and reliable way to save and use your money, we invite you to discover Glint – the payments platform that enables you to buy, sell, save, and spend real, allocated gold, even at the checkout, on anything from a coffee to a family holiday using your Glint App and Mastercard®.
At Glint, we make every effort to demonstrate a balanced conversation between gold, crypto and fiat currencies when it comes to purchasing power and, while we strongly believe that gold is the fairest and most reliable currency on the planet, we need to point out that it isn’t 100% risk free. While we have seen a steady increase over time, the value of gold can fall, which means that its purchasing power can also decline.
To learn more, visit our homepage or give us a call at +44(0)203 915 8111.
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