What Is A Fiat Currency, And What Do They Do?

Fiat Currency

Estimated reading time: 8 minutes

Fiat currency is money issued by a government that is not linked to physical reserves, such as gold.

These currencies change quickly in value because many factors, such as political stability, economic prudence, and supply and demand influence confidence in their worth.

Budgets, central bank announcements and trade agreements can also affect the market value of a fiat currency.

Modern fiat currencies include the British pound, US dollar and euro, among several other major international denominations, each guaranteed by the relevant government.

Because a commodity doesn’t back a fiat currency, the value is derived from other circumstances rather than the current value of gold. So the benefit for central banks is that they decide how much money to print, but the risk is that over-circulation can cause hyperinflation.

The Introduction Of Fiat Currencies

The word fiat comes from Latin and roughly means ‘let it be done’.

An important point to remember is a fiat currency only maintains value based on trust and confidence in the government behind it.

Until the start of World War I in 1914, British pounds were issued according to how much gold was lying in the vaults of the Bank of England, and this gold standard was the norm for the two previous centuries.

Countries would fix the gold price in their local currency, so one ounce of gold was worth £4.25 in the UK or $20.67 in the US.

Therefore, the exchange rate between the two currencies was calculated based on £1: $4.87.

Governments would guarantee that paper money and coins were redeemable for gold, and theoretically, anybody could request their cash be converted into a physical asset.

The issue with the gold standard was that the government could only print money according to the gold held in reserve. As a result, countries could not choose to devalue their currencies to improve competitiveness in international trade markets.

This inflexibility meant that the world’s money supply depended on gold mining, not on economic conditions – which meant central banks had too few courses of action to respond to economic recessions or booms.

Higher gold production could cause surges in money supplies and inflation, even if the economy were otherwise stable.

Switching From The Gold Standard To Fiat Currency

The First World War instigated the end of the gold standard, as the government suspended this approach to enable them to finance military action.

Although the UK, alongside some other countries, reintroduced the gold standard from 1925 to 1931, it reverted during the Great Depression in the late twenties and thirties.

After World War II, a type of gold standard was introduced where the US dollar was fixed to gold reserves, and some other currencies were pegged to the dollar, although this was disbanded in 1971.

However, the fiat currencies that replaced it are not without risks. If investors, banks, and businesses have no confidence in the stability of a national currency, it simply holds less value.

This differs from a representative currency, which maintains an intrinsic worth because it is linked to gold supply and demand, used extensively in the electronics, computing, aerospace and jewellery industries.

The US Dollar As A Fiat Currency

US dollars are essential because they are the most traded on global forex markets and are used more than any other denomination in international trade.

The dollar is legal tender and a form of fiat money, which holders can use for public or private debts and borrowing.

Note that fiat currency and legal tender are slightly different concepts, but most governments make fiat money legal tender by establishing the currency as the standard form for debt repayments.

Until 1933, the US government backed the dollar with gold reserves and some silver but changed this with the Emergency Banking Act.

The gold standard, which supported US dollar values with federal gold reserves, was disbanded entirely in 1971 when the US stopped using gold to purchase currency from other governments.

Today, dollars are printed with wording that states they are backed by the credit and faith of the US government, which explains how fiat currencies work and why they rely on confidence.

Pros And Cons Of Fiat Money

Fiat currencies work well when they meet national economic requirements, representing a store of value, numerical count of debts, savings, or wealth, and are used to exchange goods or services.

It is more cost-effective for governments to produce fiat currencies than to print money directly related to the amount of gold in their reserves or the demand for gold, depending on mining volumes.

One of the disadvantages of fiat money became apparent during the 2007 US mortgage crisis and financial collapse because people began to lack faith that the central bank had the power to prevent the country from falling into depression or severe recession.

Money linked to the gold standard is typically more stable and less exposed to volatility, but the limited global gold supply also hampers it. In theory, fiat money is unlimited, giving rise to greater potential for surges in demand or drops in value.

However, fiat currencies are a better fit for modern economic climates and monetary policies set by central banks because they allow significantly more control and flexibility, with the ability to address money supply issues and manage variables including:

  • Interest rates
  • Credit supply
  • Money velocity
  • Liquidity

Money velocity refers to the speed at which a currency is exchanged and the number of times a unit of money transfers from one owner or entity to the next.

Fiat currencies first became widely adopted in the 20th century, primarily because central banks and governments needed new ways to control and protect themselves from business cycles and economic boom-or-bust periods – and can actively influence how fiat currencies are produced and valued.

Today currency values are linked to the underlying economic conditions of a country rather than determined by the reserves and production of gold.

What Is A Fiat Currency, And What Do They Do FAQ

How do fiat currencies hold value?

Fiat money differs from representative currencies because it is not based on the value of a commodity and is not redeemable for any underlying asset such as gold or precious metals.

Instead, a fiat currency is backed by the issuing government and relies on trust and faith in that government to maintain its value.
The advantage of fiat currency is that governments collect taxes on the same money. Hence, a denomination maintains a perceived value in almost any circumstance because tax obligations are an ingrained aspect of modern society.

Another concept is the credit theory, which suggests that all money in any currency is a relationship between credit and debt, so it does not necessarily need a physical commodity to imply a value.

Why did countries switch from representative to fiat money?

The significant change came about when World War I began in 1914, and governments needed fast ways to issue money to finance military action – without being able to wait for gold production levels to increase.

Before then, most countries had used the gold standard or a similar policy, but the limitations on gold mining could not keep pace with the growing scope and scale of international finance and trade demands.

Central bank vaults could not validate the printing of more money, so governments changed to a fiat model to ensure flexibility around stabilising markets, financing spending, creating competition in export and import markets and setting independent monetary policies.

What alternatives are there to fiat currency?

Nearly all countries have a legal tender that is a form of fiat currency. Gold coins are still available to buy or sell but are not used for standard purchases or transactions and are more an investment or speculation asset.

Cryptocurrencies have also emerged as a variation on fiat currencies. Although they adopt some of the same principles, they challenge how fiat currencies rise and fall based on inflation.

Why can a fiat currency cause hyperinflation?

Hyperinflation can be economically disastrous when a country prints excessive volumes of a fiat currency.

However, hyperinflation has also occurred due to political instability and economic production breakdown, even where the currency was a representative denomination.

Do any countries still have a representative currency?

No countries use the gold standard or an equivalent in 2022. However, many central banks and governments still hold millions or even billions of pounds of gold in reserve as an economic asset.

Tethering physical money to gold reserves was intended to create stability but was largely abandoned in 1914 when governments needed a way to stabilise financial systems and introduce rapid economic changes.

The UK was the first to introduce the gold standard in 1717 when Sir Isaac Newton, then the Master of the Royal Mint, mistakenly set silver-to-gold exchange rates too low – causing a run on gold that meant nearly all investors traded silver for gold.

In 1821 the government officially adopted the gold standard before abandoning it in 1914. It later temporarily joined the Interwar Gold Standard in 1925 before permanently switching to a fiat currency system in 1931.

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