Fiat Money: What It Is, How It Works, Example, Pros & Cons

What Is Fiat Money?

Fiat money is a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it.

Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies.

Key Takeaways

Fiat money is a government-issued currency that is not backed by a commodity such as gold.
Fiat money gives central banks greater control over the economy because they can control how much money is printed.
Most modern paper currencies, such as the U.S. dollar, are fiat currencies.
One danger of fiat money is that governments can print too much of it, resulting in hyperinflation.

Understanding Fiat Money

The term "fiat" is a Latin word that is often translated as "it shall be" or "let it be done." Thus fiat currencies only have value because the government maintains that value; there is no utility to fiat money in itself.

Before fiat currency came about, governments would mint coins out of a valuable physical commodity, such as gold or silver, or print paper money that could be redeemed for a set amount of a physical commodity. Fiat, however, is inconvertible and cannot be redeemed simply because there is no underlying commodity backing it.

Because fiat money is not linked to physical reserves, such as a national stockpile of gold or silver, it risks losing value due to inflation or even becoming worthless in the event of hyperinflation. In some of the worst cases of hyperinflation, such as in Hungary immediately after WWII, the rate of inflation can double in a single day.

Furthermore, if people lose faith in a nation's currency, the money will no longer hold value. This is much different from a currency backed by gold, for example; it has intrinsic value because of the demand for gold in jewelry and decoration as well as in the manufacturing of electronic devices, computers, and aerospace vehicles.

History of Fiat Money in the U.S.

The U.S. dollar is considered to be both fiat money and legal tender, accepted for private and public debts. Legal tender is basically any currency that a government declares to be legal. Many governments issue a fiat currency, then make it legal tender by setting it as the standard for debt repayment.

Earlier in U.S. history, the country's currency was backed by gold (and in some cases, silver). The federal government stopped allowing citizens to exchange currency for government gold with the passage of the Emergency Banking Act of 1933. The gold standard, which backed U.S. currency with federal gold, ended completely in 1971 when the U.S. also stopped issuing gold to foreign governments in exchange for U.S. currency.

Since that time, U.S. dollars are known to be backed by the "full faith and credit" of the U.S. government, "legal tender for all debts, public and private" but not "redeemable in lawful money at the United States Treasury or at any Federal Reserve Bank," as printing on U.S. dollar bills used to claim. In this sense, U.S. dollars are now "legal tender," rather than "lawful money," which can be exchanged for gold, silver, or any other commodity.

Advantages and Disadvantages of Fiat Money

Advantages

Gives central banks greater control over the economy
Is cost-efficient to produce
Provides governments with flexibility

Disadvantages

Is not a fool-proof way to protect the economy
Creates opportunity for a bubble
Provides risk of inflation

Advantages Explained

Fiat currencies gained prominence in the 20th century in part because governments and central banks sought to insulate their economies from the worst effects of the natural booms and busts of the business cycle.

Since fiat money is not a scarce or fixed resource like gold, central banks have much greater control over its supply, which gives them the power to manage economic variables such as credit supply, liquidity, interest rates, and money velocity. For instance, the U.S. Federal Reserve has the dual mandate to keep unemployment and inflation low, and using fiat money can help it meet those goals.

Fiat money serves as a good currency if it can handle the roles that a nation's economy requires of its monetary unit: Storing value, providing a numerical account, and facilitating exchange. It also has excellent seigniorage, meaning it is more cost-efficient to produce than a currency that is directly tied to a commodity.

Disadvantages Explained

The mortgage crisis of 2007 and subsequent financial meltdown tempered the belief that central banks could necessarily prevent depressions or serious recessions by regulating the money supply.

A currency tied to gold, for example, is generally more stable than fiat money because of the limited supply of gold.

There also are more opportunities for the creation of bubbles with fiat money due to its unlimited supply.

Examples of Fiat Money

The U.S. dollar, the euro, the British pound, the Japanese yen, the Albanian lek, and the Indian rupee are all examples of fiat money.

Because it's a currency that is backed by an issuing government, fiat money usually provides some economic stability—but not always.

The African nation of Zimbabwe provided an example of the worst-case scenario in the early 2000s. In response to serious economic problems, the country's central bank began to print money at a staggering pace, resulting in hyperinflation.

Experts suggest the currency lost 99.9% of its value during this time. Prices rose rapidly and consumers carried bags full of money just to purchase basic staples. At the height of the crisis, the government of Zimbabwe was forced to issue a 100-trillion Zimbabwean dollar note. Eventually, foreign currencies were used more widely than the Zimbabwean dollar.

Why Is Fiat Money Valuable?

In contrast to commodity-based money, such as gold coins or paper bills redeemable for precious metals, fiat money is backed entirely by the full faith and trust in the government that issued it. One reason this has merit is that governments demand that you pay taxes in the fiat money it issues. Since everybody needs to pay taxes, or else face stiff penalties or prison, people will accept it in exchange (this is known as chartalism).

Other theories of money, such as the credit theory, suggest that since all money is a credit-debt relation, it does not matter if money is backed by anything to maintain value.

Why Do Modern Economies Favor Fiat Money?

Prior to the 20th century, most countries utilized some sort of gold standard or backing by a commodity. As international trade and finance grew in scale and scope; however, the limited amount of gold coming out of mines and in central bank vaults could not keep up with the new value that was being created, causing serious disruptions to global markets and commerce.

Fiat money gives governments greater flexibility to manage their own currency, set monetary policy, and stabilize global markets. It also allows for fractional reserve banking, which lets commercial banks multiply the amount of money on hand to meet demand from borrowers.

What Are Some Alternatives to Fiat Money?

Virtually every country today has legal tender that is fiat money. While you can buy and sell gold and gold coins, these are rarely used in exchange or for everyday purchases and tend to be more of a collectible or speculative asset.

Cryptocurrencies, such as Bitcoin, emerged over the past decade as a challenge to the inflationary nature of fiat currencies, but despite increased interest and adoption, these virtual assets do not seem to approach being "money" in the traditional sense.

Does Fiat Money Lead to Hyperinflation?

There is always the possibility of hyperinflation when a country prints its own currency. However, most developed countries have experienced only moderate bouts of inflation. In fact, having some consistent, low level of inflation is seen as a positive driver of economic growth and investment, as it encourages people to put their money to work rather than have it sit idle and lose purchasing power over time.

Having a relatively strong and stable currency is not only a mandate of most modern central banks, but a rapidly devalued currency is harmful to trade and obtaining financing.

Moreover, it is unclear whether or not hyperinflation is caused by "runaway printing" of money. In fact, hyperinflation has occurred throughout history, even when money was based on precious metals; and all contemporary hyperinflation has begun with a fundamental breakdown in the real production economy and/or political instability in the country.

The Bottom Line

Fiat money derives its value from supply and demand, not an underlying physical commodity. Governments use fiat money to create economic stability and help protect against the booms and busts that are natural parts of the business cycle. However, the overproduction of fiat money risks inflation or even hyperinflation by increasing supply beyond demand.