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

what is fiat money backed by

The value of fiat money is not determined by the material with which it is made. The metals used to mint coins and the paper used for bills are not valuable in themselves. The succeeding Yuan Dynasty was the first dynasty of China to use paper currency as the predominant circulating medium. The founder of the Yuan Dynasty, Kublai Khan, issued paper money known as Jiaochao during his reign. The original notes during the Yuan Dynasty were restricted in area and duration as in the Song Dynasty.

what is fiat money backed by

Even though the Federal Reserve controls the money supply, it was not able to prevent the crisis from happening. Critics of fiat money argue that the limited supply of gold makes it a more stable currency than fiat money, which has an unlimited supply. Fiat currency, also called fiat money, is legal tender whose value is backed by the government that issued it.

Advantages and Disadvantages of Fiat Money

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. Commodity-based currencies were volatile due to the regular business cycle and periodic recessions. The central banks can print or hold paper money as they may need, giving them greater control over the money supply, interest rates, and liquidity. For example, the Federal Reserve’s control over the money supply and demand enabled it to manage the Global Financial Crisis of 2008 from causing greater harm to the U.S. financial system and global economy. The value of fiat money depends on supply and demand and was introduced as an alternative to commodity money and representative money.

With a fiat currency, the money supply can be increased far more easily as demand increases, helping to stabilize a currency’s spending power and preventing deflation, or the falling price of goods. If the U.S. and other nations had remained on a gold standard, the world’s supply of money would be limited to the available gold. And while the amount of gold on earth hasn’t increased much over billions of years, the human population, its economic output, and the demand for money certainly have gone up. 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. Bitcoins and other cyber currencies are not backed by any government or other authority and are not fiat currencies.

A more recent example is the currency instability in Venezuela that began in 2016 during the country’s ongoing socioeconomic and political crisis. American colonies, France, and the Continental Congress started issuing bills of credit that were used to make payments. The provincial governments issued notes that the holders would use to pay taxes to the authorities.

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. The U.S. severed its ties with the gold standard in 1971, turning its currency into fiat money. As a result, all other national currencies came to be valued against the U.S. dollar. In modern economies, relatively little of the supply of broad money is physical currency.

What is Fiat Money?

While fiat money doesn’t have intrinsic value, its value is set by the government that issues the currency. Fiat money can be used to buy goods and services because both parties involved in a transaction agree on the currency’s value. A country that followed the gold standard set a fixed price for gold, buying and selling it at that price. So if Britain set the price of gold at £500 an ounce, the value of the dollar would be 1/500th of an ounce of gold.

Most coin and paper currencies that are used throughout the world are fiat money. This includes the U.S. dollar, the British pound, the Indian rupee, and the euro. All these pieces of paper are issued with as much solemnity and authority as if they were of pure gold or silver… In monetary economics, fiat money is an intrinsically valueless object or record that is accepted widely as a means of payment.[1] Accordingly, the value of fiat money is greater than the value of its metal or paper content. Unlike the traditional commodity-backed currencies, fiat currency cannot be converted or redeemed. For a fiat currency to be successful, the government must protect it against counterfeiting and manage the money supply responsibly.

  1. This includes the U.S. dollar, the British pound, the Indian rupee, and the euro.
  2. This can result in big economic shocks, forcing companies to cut costs, lay off workers, or take other actions to stave off losses in a deflationary environment.
  3. Tether (USDT 0.04%), which is “tethered” to the U.S. dollar, is the largest.

And, as we have seen over the past several years as many have gained immensely in value, they can hedge your wealth against inflation. Increasing the money supply may sound like a central bank, such as the U.S. Federal Reserve Board, can just magically make money appear out of thin air. The Fed doesn’t so much create money out of thin air as exchange newly made money for an asset, such as a loan to a bank, a U.S.

Treatment in economics

Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies. Fiat money has been the dominant form of currency since the United States, and then the rest of the world, dropped the gold standard in the 1970s. That is, the cash has the value that a government attaches to it and does not represent a store of equal value, such as gold. This is not determined by the worth of the material that is used to produce it, and it is not backed by a commodity of equal value. It has the value that the government says it has, whether that is a nickel or $100.

The most important feature of fiat money is the stability of its value, unlike commodity-based money like gold, copper, and silver. The use of fiat money became popular in the 20th century as governments and banks moved in to protect their economies from the frequent busts of the business cycle. A fiat currency functions well when the public has enough confidence in the currency’s ability to act as a storage medium for purchasing power.

As the finances of the French government deteriorated because of European wars, it reduced its financial assistance to its colonies, so the colonial authorities in Canada relied more and more on card money. By 1757, the government had discontinued all payments in coin and payments were made in paper instead. In an application of Gresham’s Law – bad money drives out good – people hoarded gold and silver, and used paper money instead. The costs of the Seven Years’ War resulted in rapid inflation in New France. After the British conquest in 1760, the paper money became almost worthless, but business did not end because gold and silver that had been hoarded came back into circulation. By the Treaty of Paris (1763), the French government agreed to convert the outstanding card money into debentures, but with the French government essentially bankrupt, these bonds were defaulted and by 1771 they were worthless.

What Are Some Alternatives to Fiat Money?

It is backed by a deposit of cash or some other commodity that is stored by the payer and ready to be handed over to the payee. Although they have no physical existence, they can be exchanged for other commodities and currencies. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer. The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on, top-rated podcasts, and non-profit The Motley Fool Foundation. 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.

Often nations would have dual currencies, with paper trading at some discount to money which represented specie. The Bretton Woods Agreement fixed the value of one troy ounce of gold to 35 United States Dollars. However, in 1971, United States President, Richard Nixon, introduced a series of economic measures including canceling the direct convertibility of dollars into gold due to declining gold reserves. Since then, most countries have adopted fiat monies that are exchangeable between major currencies.

As the colony expanded, coins from France came to be used widely, but there was usually a shortage of French coins. In 1685, the colonial authorities in New France found themselves seriously short of money. A military expedition against the Iroquois had gone badly and tax revenues were down, reducing government money reserves.