What Are Fiat Currencies & How Do They Work?
Fiat currency is a type of money that is created by a government and is not backed by a physical commodity like silver or gold. In other words, it is backed by the perceived stability and authority of the government that issued it and doesn’t represent an actual, physical store of value like gold bullion. Today, the most commonly used currencies in the world—like the U.S. dollar and the euro—are fiat currencies.
When a country uses a fiat currency as its primary store of value and means of exchange, the country’s government is typically responsible for the creation of the money as well as the regulation of its supply. In the U.S., a central bank known as the Federal Reserve makes policy decisions that essentially increase or decrease the total supply of U.S. dollars in circulation in the country’s economy.
Fiat currencies are traded on the foreign exchange market, or “forex,” based on conversion rates that are determined by supply and demand. Additionally, many countries that use fiat currencies hold the fiat currencies of other countries in their reserves in order to diversify their assets.
Why Do Fiat Currencies Like the Dollar Have Value?
As mentioned above, fiat currencies aren’t backed by physical commodities. $100 cannot be taken to a Federal Reserve bank and exchanged for $100 worth of gold or silver, although this used to be the case when the U.S. was on the gold/silver standard. Nevertheless, dollars are considered “legal tender for all debts, public and private” according to the blurb printed on every dollar bill.
So then, why do U.S. dollars (and other fiat currencies) have value? Why are hundreds of millions of Americans willing to accept them in exchange for tangible goods and valuable services? The word “fiat” means order, authorization, or decree—and in a sense, a fiat currency has value because the issuing government says that it does.
In reality, the value of a fiat currency depends almost entirely on the perceived sanctity of the issuing body—usually a country’s government. U.S. dollars, for example, are backed by the “full faith and credit of the U.S. government.” Because the U.S. government is seen both domestically and internationally as a creditworthy entity, the currency it issues is considered valuable.
Domestically, U.S. dollars have value because residents depend on them. Residents are paid by their employers in U.S. dollars, spend money in U.S. dollars, accept payments for goods and services in U.S. dollars, and—perhaps most importantly—pay taxes to the federal government in U.S. dollars. In this sense, the government assures its citizenry that dollars have value by accepting only dollars for tax payments and taxing residents at rates that depend on how many dollars they make.
The U.S. is also a major international economic power, and many foreign governments hold U.S. dollars in their international reserves. Together, these factors help keep the dollar valuable internationally in relation to other fiat currencies that trade on the forex market.
How Is Fiat Money Created?
Fiat money can be created in a variety of ways. About 10% of the total money supply in the U.S. exists in physical form as bills and coins. Bills are printed by the Treasury Department's Bureau of Engraving and Printing, while coins are created by the U.S. Mint. Both of these are government agencies that produce physical money in set amounts when instructed to by the Federal Reserve.
In the modern day, however, most of the country’s money supply exists only electronically—it moves around digitally between credit cards, checking accounts, bank reserves, and the like. To create more of this type of money, the Fed simply purchases Treasury securities from banks. In other words, it trades money for bonds.
When pundits talk about the Fed “printing money,” this is by and large what they mean. The money the Fed spends on these treasury securities enters the economy, increasing the total money supply in circulation.
On the other hand, when the Fed wants to decrease the money supply, it sells Treasury securities, adding the cash proceeds to its balance sheet and removing them from circulation.
What Are the Advantages and Disadvantages of Fiat Currencies?
The primary advantage of fiat currency is its convenience. It is convenient for consumers because, within the country that issues it, it is universally accepted—everyone is paid in it, and everything can be bought with it. It is also convenient for the government, as it can be added to or removed from the economy quickly and efficiently. This gives a country’s central bank the ability to easily regulate the money supply in response to issues like recession. Additionally, since fiat money isn’t tied to a commodity, its value doesn’t fluctuate along with the value of a commodity.
Fiat money has its downsides, though. For instance, if the central bank that manages a country’s money supply adds too much of it to the economy too fast, inflation can accelerate at an unstable rate, resulting in a phenomenon known as hyperinflation that can have devastating economic consequences. Because of its theoretically unlimited supply, the use of fiat currency can lead to asset bubbles and devaluation if mismanaged by its issuing body.
Example: Fiat Currency and Hyperinflation in Germany and Zimbabwe
When a fiat currency is overprinted and becomes devalued rapidly as a result, residents often abandon it in favor of commodities or more stable foreign currencies. This phenomenon famously occurred in the Weimar Republic in Germany in the early 1920s and in Zimbabwe in the early 2000s. In both cases, the countries’ respective governments printed too much money too quickly in response to economic issues, and in both cases, hyperinflation ensued until the currencies were devalued to such a degree that they became impractical to use.
3 Alternatives to Fiat Currencies
Fiat currency is far from the only store of value and instrument of trade that exists. Its best-known alternatives include commodities (and/or commodity-backed currencies), cryptocurrencies, and bartering.
Commodities and Commodity-Backed Currencies
Commodities can–and frequently have—served as currencies. For example, metals like gold and silver can be minted into coins of various weights and denominations that can then be exchanged for goods and services.
Alternatively, paper money or certificates can be created to represent actual commodities (that are held in a central bank) and then used as legal tender. When this is the case, holders of commodity-linked bills can typically exchange the bills for a pre-determined amount of the linked commodity at a central bank. U.S. dollars functioned this way over several periods throughout the country’s history, the most recent lasting from 1944 to 1971.
Commodities and commodity-backed currencies are limited in that they cannot be created or destroyed at will (because commodities are relatively scarce), so the money supply cannot be easily increased or decreased over a short period in response to economic pressures. Additionally, the ability to redeem bills for their linked commodity leaves the system vulnerable to a “run” on that commodity, wherein many residents redeem bills over a short period, depleting the circulating money supply and the central bank’s reserve of the backing commodity simultaneously.
Cryptocurrencies
Cryptocurrencies, which came into popular use around 2010, are another alternative to fiat currencies. These are digital currencies that, rather than depending on a central bank, depend on a decentralized “blockchain” that serves as a sort of unalterable, chronological ledger of transactions and custody.
While popular for their decentralized nature, practicality, and international appeal, cryptocurrencies come with several downsides including high energy usage, volatility, and susceptibility to scams and hacks in certain cases.
Bartering
Bartering is likely the oldest and simplest monetary system. In a bartering economy, goods and services are traded directly between businesses and consumers according to their perceived value. For instance, a container of grain could be exchanged for a night’s stay at an inn if the two had equal value in the eyes of those involved in the transaction.
Bartering has many disadvantages, and most of them come down to inconvenience. For instance, while a container of grain might hold equal value to a stay at an inn, the innkeeper in question may have no interest in a container of grain and therefore no reason to make the trade. Alternatively, the two individuals involved in a potential transaction might have different perceptions of the worth of the goods and services involved, which could make completing an agreeable transaction difficult.
Frequently Asked Questions (FAQ)
Below are answers to some of the most common questions investors have about fiat currencies.
How and When Did the U.S. Dollar Become a Fiat Currency?
Most recently, the U.S. dollar became a fiat currency between 1971 and 1973. Before this, it was a commodity-linked currency for over a quarter century.
On August 15th, 1971, then-president Nixon announced that the dollar would no longer be backed by gold, beginning the process of phasing out its commodity-linked status. On March 16th, 1973, congress officially decoupled the dollar from any gold backing, completing its transition into a fiat currency backed only by the full faith and credit of the U.S. government. Interestingly, the value of gold went up significantly after this occurred.
Does Fiat Currency Have Intrinsic Value?
Fiat currencies do not have intrinsic value because they lack inherent utility. In other words, they are only useful as stores of value and means of transaction because a government declares that they are. Without the authority of an issuing government and subsequent status as legal tender, a fiat currency would serve no purpose and therefore have no value. A commodity like gold, on the other hand, has intrinsic value because it is scarce, tangible, and useful.
What Is the Most Popular Fiat Currency?
In terms of trading volume on the foreign exchange market, the U.S. dollar is the most popular, with an average daily trading volume of around U.S. $2.9 trillion.
What Is the Oldest Fiat Currency?
When it comes to fiat currencies that are still used today, the British pound is the world’s oldest, having been in use since 1694.
What Was the First Fiat Currency?
The first known fiat currency was the jiaozi, which was issued and regulated by China’s Song Dynasty during the 11th century CE.
