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

What Is Fiat Money?

Fiat money is a government-issued currency that's not backed by a physical commodity such as gold or silver. It's backed by the government that issues 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's often translated as "it shall be" or "let it be done." Fiat currencies only have value because the government maintains that value. There's no utility to fiat money in itself.

Governments would mint coins out of a valuable physical commodity such as gold or silver before fiat currency came about. They might have printed paper money that could be redeemed for a set amount of a physical commodity. Fiat is inconvertible, however. It can't be redeemed because there's no underlying commodity backing it.

Fiat money isn't linked to physical reserves such as a national stockpile of gold or silver so it risks losing value due to inflation. It might even become worthless in the event of hyperinflation. The rate of inflation can double in a single day in some of the worst cases of hyperinflation, such as in Hungary immediately after WWII.

The money will no longer hold value if people lose faith in a nation's currency unlike a currency backed by gold. This type of currency 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. It's accepted for private and public debts. Legal tender is any currency that a government declares to be legal. Many governments issue a fiat currency and then make it legal tender by setting it as the standard for debt repayment.

The country's currency was backed by gold and in some cases silver earlier in U.S. history. 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 backed U.S. currency with federal gold but it ended completely in 1971 when the U.S. also stopped issuing gold to foreign governments in exchange for U.S. currency.

U.S. dollars have been backed by the "full faith and credit" of the U.S. government since that time. They're "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 the printing on U.S. dollar bills used to claim. U.S. dollars are "legal tender" rather than "lawful money" in this sense, 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

Isn't a foolproof way to protect the economy
Creates an 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.

Fiat money isn't a scarce or fixed resource like gold so central banks have much greater control over its supply. This gives them the power to manage economic variables such as credit supply, liquidity, interest rates, and money velocity. 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. It's more cost-efficient to produce than a currency that's 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 is generally more stable than fiat money because of the limited supply of gold.

There are also more opportunities for the creation of bubbles with fiat money because of 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. It's a currency that's backed by an issuing government so 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. The country's central bank began to print money at a staggering pace in response to serious economic problems, resulting in hyperinflation.

Experts suggest that 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. The government of Zimbabwe was forced to issue a 100-trillion Zimbabwean dollar note at the height of the crisis. Foreign currencies were eventually used more widely than the Zimbabwean dollar.

Why Is Fiat Money Valuable?

Fiat money is backed entirely by the full faith and trust in the government that issued it in contrast to commodity-based money such as gold coins or paper bills redeemable for precious metals. This has merit because governments demand that you pay taxes in the fiat money it issues. Everybody must pay taxes or face stiff penalties or prison so people will accept it in exchange. This is known as chartalism.

Other theories of money such as the credit theory suggest that all money has a credit-debt relation so it doesn't matter if money is backed by anything to maintain value.

Why Do Modern Economies Favor Fiat Money?

Most countries used some sort of gold standard or backing by a commodity before the 20th century. The limited amount of gold coming out of mines and in central bank vaults couldn't keep up with the value that was being created, however, as international trade and finance grew in scale and scope. This caused serious disruptions to global markets and commerce.

Fiat money gives governments greater flexibility to manage their 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 has legal tender that's fiat money. You can buy and sell gold and gold coins but these are rarely used in exchange or for everyday purchases. They tend to be more of a collectible or speculative asset.

Cryptocurrencies such as Bitcoin have emerged as a challenge to the inflationary nature of fiat currencies. These virtual assets don't seem to approach being "money" in the traditional sense, however, despite increased interest and adoption.

Does Fiat Money Lead to Hyperinflation?

There's always the possibility of hyperinflation when a country prints its own currency but most developed countries have experienced only moderate bouts of inflation. A low level of inflation is seen as a positive driver of economic growth and investment because 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 isn't only a mandate of most modern central banks. A rapidly devalued currency is harmful to trade and in obtaining financing.

It's unclear whether hyperinflation is caused by the "runaway printing" of money. It's occurred throughout history, even when money was based on precious metals. 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 from 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. The overproduction of fiat money risks inflation or even hyperinflation by increasing supply beyond demand, however.