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What is Fiat Money?

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Synopsis:

A currency issued by a government that is not backed by a physical commodity, like gold or silver, is called fiat money. The only source of value for a fiat currency is a government’s backing and the trust of the people in their government. Fiat currencies have been dominating the economic landscape since the 20th century onwards when many governments realised that they could deal with economic booms and busts better with a paper currency than with commodity money.

What is Fiat Money?

When a government issues currency, it is called "fiat money." Physical commodities, like gold or silver, do not back such currencies. The value of fiat money is a function of its demand and supply. The stability of the government issuing currency also impacts the value of fiat money. Most paper currencies, such as Indian Rupee, US Dollar, and Euro are examples of fiat money.

Understand Fiat Money Meaning

“Fiat” is a Latin word, which means “let it be done.” It is used in the sense of a decree, which is backed by authority. On the same lines, fiat money has only one source of value, which is a government’s backing. As fiat currencies are not backed by physical commodities, such as silver or gold, their value is derived from the backing of a government.

And, people value their currency only because it is backed by a government. In case, a government is not stable, then its currency may lose value.

In the olden days, governments used to mint coins using a physical commodity of value. However, in modern times, governments started to print currencies. As these currencies are not backed by a valuable commodity, they lose value due to inflation. In fact, in the case of hyperinflation, fiat currencies may lose their entire value. Now that we have learnt what fiat money is or its meaning, let us delve deeper into this topic.

How Does Fiat Money Work?

As discussed, fiat money works based on a government’s backing and the trust of the people in their government. A central authority, typically a central bank, issues fiat money. For example, in India, the Reserve Bank of India (RBI) issues the currency on behalf of the government.

So, a government or central authority issues a paper currency, and the amount printed on it is accepted by people as its value. This sounds arbitrary and precisely for this reason, it is called fiat money.

The other important characteristic of fiat money is that it is a legal tender. No one in a country can refuse to accept a fiat currency as a medium of exchange because it is a legal tender.

The value of a fiat currency is based on many factors, including the demand and supply of a currency. If a government increases the supply of its fiat currency, it may lose value to an extent.

Advantages of Fiat Money

The main advantages of fiat money are explained below:

  • Better control for central banks: Fiat money is not backed by physical commodities. Hence, a central bank does not have to worry about getting stockpiles of gold or silver to issue its currency. Fiat money is in the form of a paper currency. Therefore, central banks have much better control over fiat currencies. As a result, central banks can change the supply of fiat money based on factors, like liquidity, interest rates, and credit supply.

  • Efficient medium of storing value and exchange: When a fiat currency performs well, it can be an efficient medium to store monetary value. Besides, it can be used for exchange. In other words, when people buy goods or services in a country, they can pay in a fiat currency.

Disadvantages of Fiat Money

While fiat money has its benefits, it also has a few disadvantages, which are explained below:

  • Can lose value due to inflation: Fiat money is a paper currency, which is not backed by a physical commodity. Therefore, its value declines over a period of time due to inflation. Hence, if you keep just paper currencies at home without investing them properly, your money will lose value owing to inflation.

  • Political instability can harm fiat money’s value: When a country’s government is unstable, its fiat currency may lose value. Unstable governments often have erratic policies, which results in people losing faith. Hence, fiat money is prone to political instability. This is why the most stable currencies in the world are of countries with the most stable governments.

Fiat Money Examples

We see the examples of fiat money all around us in our daily lives. For example, Indian Rupee, US Dollar, Euro, British Pound Sterling, Japanese Yen, Australian Dollar, Canadian Dollar, etc. are all examples of fiat money.

All these currencies are issued by their respective government. Their value is a function of the backing of their government and the faith of the people in that government. None of these currencies are backed by a physical commodity.

If a country’s government is stable, chances are high that its currency too is stable. However, if for some reason, a government or its central authority, is unstable, then its currency may lose value.

For example, in the early 2000s, Zimbabwe's central bank started printing currency at a very high pace to deal with economic problems. As the supply of currency increased rapidly, it caused hyperinflation. Consequently, people in Zimbabwe were reported to carry bags full of currency to buy basic groceries.

Conclusion

Fiat money certainly has its benefits. A government can increase or decrease the supply of its fiat currency based on its country’s economic situation. That said, fiat money can be used by a government only up to a point. For example, the mortgage crisis that happened in the US in 2007 and the resultant meltdown showed that economic recessions cannot be prevented by just regulating the money supply. Hence, governments are responsible for maintaining the health of their economy so that they can deal with ups and downs without always resorting to money supply adjustments.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

Frequently Asked Questions

1. What is the meaning of fiat money?

Answer Field

Fiat money is backed by the government issuing it. It is not backed by a physical commodity, like gold or silver. A fiat currency derives its value because the people of a country trust the currency issued by their government.

2. Fiat money is backed by the government issuing it. It is not backed by a physical commodity, like gold or silver. A fiat currency derives its value because the people of a country trust the currency issued by their government.

Answer Field

Fiat money is not backed by a physical commodity. Hence, a government or its central authority can print as much fiat currency as it wants based on factors like inflation, interest rate, etc. However, commodity money is backed by reserves of physical commodities.

Why do governments use fiat money?

Answer Field

Governments use fiat money because they have more control over its supply than they have over the supply of commodity money. Hence, fiat money helps them deal with ups and downs in their economy relatively easily.

4. What are the advantages and disadvantages of fiat money?

Answer Field

A central authority has more control over fiat money because it can be issued without worrying about the stock of a physical commodity. However, fiat money is prone to inflation and political instability.

5. How is the value of fiat money determined?

Answer Field

The value of fiat money is based on its demand and supply. It is also a function of the trust the people have in their government. Besides, other factors like interest rates and inflation also affect its value.

6. Is cryptocurrency considered fiat money?

Answer Field

No, cryptocurrencies are not fiat money. Cryptocurrencies are not issued by a government or central authority. They are decentralised; hence, they cannot be considered as fiat money.

7. What role does fiat money play in the global economy?

Answer Field

Fiat currencies like US Dollar, Japanese Yen, and Indian Rupee are used worldwide for international trade. Besides, these currencies are also trusted by people and institutions while making investments.

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