FIAT MONEY

 

What Exactly Is Fiat Money?

Could you picture purchasing your weekly groceries while carrying gold? Instead of the paper money we are all used to today, people used gold as payment for goods and services earlier in history. Today, however, we trade goods for money such as the US dollar, the euro, and even cryptocurrencies instead of gold.

The value of fiat currency, often known as fiat money, is guaranteed by the overnment that issued it. This is distinct from money that is supported by a tangible good that determines its worth, like gold.

It's a popular myth that fiat currencies have "nothing" supporting them, in contrast to currencies of the past that were based on a gold, silver, or other precious metal standard. A better way to put it is that a fiat currency is supported by the assets of the government that issues it, and that its value is influenced by a variety of variables such as economic supply and demand, interest rates, and the money supply.

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An Overview of Modern Currency History

In more recent centuries, money was composed of a physical product of agreed-upon worth, most frequently a metal like gold, silver, copper, or bronze. The British pound sterling, which started off as a silver coin weighing one troy pound, is the best example. Literally, it said: one pound of sterling silver. These actual coins have worth in the coin itself.

Governments then started issuing paper money, or notes that could be redeemed for a unit of the underlying standard. Since the 1700s, gold has been the solution for the British pound sterling. Up until 1933, one dollar could be exchanged for one ounce of gold in the US.

Governments have shifted away from the gold standard throughout the last century. Today, practically all currencies are supported by the governments that issue them. The dollar is a prime example of a fiat currency. In 1976, the U.S. government formally terminated the exchange rate between gold and the dollar.

 

The Benefits of Fiat Money

The inability of a government to react to economic circumstances is the main reason why nations stopped utilizing a gold standard. A country's need for money varies depending on the growth of its population and economy, as opposed to a gold standard, where the money supply is linked to the amount of gold that is readily available.

Take the U.S. as an illustration. Both the population and the economy have experienced rapid growth since the dollar's decoupling from gold:

The amount of available gold would have been the only source of money in the world if the U.S. and other countries had continued to operate on a gold standard. And over the course of billions of years, while the amount of gold on Earth hasn't significantly increased, the human population, its economic production, and the demand for money unquestionably have.

With a fiat currency, the money supply may be expanded far more quickly in response to rising demand, helping to stabilize a currency's purchasing power and avert deflation, or the decline in the price of products.

Before you respond, "Falling prices are fantastic," keep in mind that every purchase has a producer on the opposite side. For producers, a price decline can be fatal, especially if it occurs quickly. Large economic shocks can arise from this, causing businesses to make cost cuts, fire employees, or take other measures to prevent losses in a deflationary climate. Consequently, more firms may suffer as a result of client losses or decreased spending by customers, which could result in further budget cuts and job losses.

Here's an illustration of the first benefit of using fiat money: the ability to control the amount of money in circulation so as to avoid an eventual collapse of the economy due to deflation.

A fiat currency also has the benefit of being able to support the debt markets and be utilized to promote economic instability. A central bank may add assets to its own balance sheet, as was done when the Fed bought mortgages and federal debt issued by the United States.

It may sound that a central bank, like the U.S. Federal Reserve Board, can just magically create money out of thin air by increasing the money supply. That is somewhat accurate, but it is also oversimplified. The Fed exchanges newly generated money for an asset, such a loan to a bank, a U.S. Treasury bond, rather than creating money out of thin air.

Treasury bonds or securities secured by mortgages. In other words, when the Fed "creates" new money, it does so in response to actual market demand.

 

Cons of Using Fiat Money

Fiat currency carries two main risks: mismanagement of the money supply and political instability.

Let's discuss the state of the political system. Money, whether it be fiat or gold-backed, is a collective construct that only has value because everyone agrees it does. The foundation of fiat currency is the belief that the government issuing it will be stable and in power, maintaining the currency's value at what we all agree upon. Without a reliable, efficient, and resourceful administration, confidence in a fiat currency may decline, which could lead to high inflation as it loses purchasing power.

With fiat currencies, many people worry about the potential of improper management of the money supply, especially as the money supply is increased. Due to the tremendous government stimulus efforts made during the COVID-19 pandemic in 2020 and 2021, many people find this to be of particular concern. In the U.S., for instance, the money supply surged by about 40% between January 2020 and December 2021:

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Fiat Money And Cryptocurrencies

Numerous people are now thinking about cryptocurrencies due to concerns about inflation and governmental control of the currency and economic policy. Cryptocurrencies are particularly interesting to anyone who is wary of government manipulation of the currency because they are a decentralized digital asset. They are also becoming more and more beneficial as portable, digital value repositories. They can also protect your money against inflation, as we have witnessed over the past several years as many have appreciated significantly in value.

The innovation in usage occurring on the blockchain may increase the value of the cryptocurrencies on the strongest, safest, and most effective blockchain networks.

In the future, fiat money might also evolve into cryptocurrency. A government-built and -backed cryptocurrency appears to be all but inevitable at some time given that numerous countries have started exploring digital currency. In 2021, El Salvador made Bitcoin (CRYPTO:BTC) a recognized form of money.

Stablecoins are a type of cryptocurrency that are currently linked to the value of fiat money. The biggest is Tether (CRYPTO:USDT), which is "tethered" to the US currency.

 

Fiat and Commodity Currencies

Commodity money has intrinsic value, which entails that it has a real or perceived worth. This kind of money is made from a valuable substance, like gold or silver. Contrarily, fiat money has no inherent worth. Consider $1 bills. Although they are all made of the same paper, the value of a dollar bill might vary based on what the government considers it to be worth.

 

Representative Money And Fiat Money

The government also creates representative money, but unlike fiat money, it is backed by a real asset. There are various types of representational money, including cheques and credit cards, which show an intent to pay.

Although representational money can be supported by many assets, fiat money is always backed by the government. A check or credit card's value is guaranteed by the funds in a bank account.

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Fiat Currency's Future

Since fiat money is now accepted as legal tender in almost every nation, it is difficult to predict what the future may contain. Fiat money provides governments more control over a country's economy, so even while cryptocurrencies are growing quickly and some experts think they may ultimately completely replace fiat currency, we should anticipate it to be the main form of commerce for years to come.