What Is Fiat Currency?

Fiat currency is a unit of account, medium of exchange, store of value, and in most cases, legal tender accepted for private and public debts. It is issued by a government according to the forces of demand and supply and derives its value from the political and economic stability of the issuing government. Most fiat currencies exist as paper money and are based on the faith and credit of the issuing government rather than backed by an inherently valuable asset like gold.

Although fiat currency has no inherent value, it is the backing by the government that establishes its fulfillment of the criteria for being cash or money. Fiat currencies are susceptible to inflation but help the government manage the economy. Governments maintain economic stability through expansionary and contractionary monetary policies. The government can simply reduce the fiat reserve requirement of banks to increase investment and push the economy to its full potential or increase banks' cash reserve requirements to reduce spending when aggregate expenditure is above full employment.

Most currencies were tied to physical assets like gold or silver. With the expansion in the global economy and the need to expand the economy, these metals were no longer enough to account for every dollar or fiat currency in circulation. The events led to the passing of the Emergency Banking Act in 1933 and the effective removal of the gold standard, which only allowed the minting of dollars per ounce of gold. Following these events, central banks were saddled with the responsibility for minting money with legal tender status provided by the government under the law of the issuing country. The dollar was no longer redeemable for gold at the United States treasury, which removed its status as lawful money. Being lawful money meant that each currency unit represented an ounce of a precious metal like silver or gold.

Summary of Important Points

• Fiat currency is a medium of exchange, unit of account, and store of value and legal tender in the country where it was issued.
• Most fiat currencies exist as paper money backed by faith in the issuing economy and government.
• The government uses fiat currency to maintain stability in the issuing economy through contractionary and expansionary monetary policies.
• Most currencies were issued per ounce of precious metal before fiat currency came into being.
• Fiat currencies have no intrinsic value or other use-cases like precious metals; hence they are susceptible to inflation.
• Fiat currency meets the good money requirements by being acceptable, recognizable, homogenous, relatively stable, recognizable, and portable.

Features of Fiat Currency

Portable

Fiat currency is money that possesses the qualities of general acceptability because everyone in the issuing country will accept it for some quantity of something else. It can also be used outside the issuing country using the floating exchange rate of goods and services in the international economy. It is also portable because you can carry the dollar bills around.

Divisible

Fiat money is divisible since having a $100 bill is the same as having five $20 bills. You can also divide that further into one-dollar bills, in which case you would need a hundred bills to reach the same amount.

Recognizable

Fiat currency is also recognizable by anyone who sees it because it doesn’t change except, of course, the person in question has never seen the fiat currency prior. It is also reasonably stable compared to other assets, and the change in value is accounted for in inflation. Fiat currency is traded on the international stock exchange, where each unit compares one currency to another in a pair trading system.

What Makes Fiat Currency Valuable?

Fiat currency is valuable because it is backed by the highest institution of the state; hence, fiat currency can be called a tool of the government. Governments across the globe use fiat currency for public debt settlement, and the value of a currency is determined by the performance of that economy in the international market. Hence if a country’s nominal GDP is low, the currency's value relative to other currencies will be low in the international market. Currencies like the United States Dollar are also considered the global reserve currency. This implies that other countries of the globe believe in the US economy and would love to hold the US dollar in their reserve to hedge against economic uncertainties.

Are There Alternatives to Fiat Currency?

The most common alternative to fiat currencies today are cryptocurrencies developed to curb the excesses of fiat currency minted arbitrarily by the government. The first and most acclaimed cryptocurrency, Bitcoin, is fixed at a total maximum supply of 21 million, after which no more Bitcoin can be minted.

Bitcoin is also decentralized, which means that no one can create Bitcoin out of thin air in the way that governments can mint fiat currencies. Bitcoin and other cryptocurrencies have not been able to pass as money because, like gold and precious metals, they have uses other than serving as a currency.

Cryptocurrencies are therefore viewed as highly speculative assets by the government of various countries. Unlike fiat currency, it is hard and sometimes impossible to track cryptocurrency transactions. Governments have also cited this as a problem because it makes cryptocurrency a haven for criminals and illegal activities.

Advantages of Fiat Currency

Stabilization

Fiat currency is the tool used by governments across the globe to control the ebb of economic activities and prevent difficult economic situations.

Seigniorage

Seigniorage is the cost of minting a currency. It is cheaper to add more notes to an economy with fiat currency than with gold-backed money, where the issuing country must boast of an equivalent gold reserve for every note issued.

Liquidity

Fiat currency is the basis for fractional reserve banking. Since it is not limited in supply like gold, countries can mint more notes in response to increasing demand. Doing this will stimulate economic activities and keep the level of unemployment low.

Disadvantages of Fiat Currencies

Inflation

Central banks can start to print money at a staggering pace resulting in hyperinflation, a situation in which money loses its value. Governments can misuse the trust by minting an insane amount of cash.

Lack of intrinsic value

Another argument against fiat currency is its lack of intrinsic value. Fiat currency is intrinsically pieces of paper that are as valuable as we believe them to be. Unlike gold or digital currencies, an inherent use-case of Fiat currencies is impossible to show.

Centralization

Centralization puts the fate of the majority on the whims of the few. It is an unfair public situation that has been argued against by proponents of cryptocurrencies. Entrusting the government to mint the medium of exchange, store of value, and unit of account of a people comes with its risks. It would be better to trust no one in a decentralized money system.