Fiat money is currency that a government has declared to be legal tender, but it is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material from which the money is made.
BREAKING DOWN ‘Fiat Money’
Fiat money only has value because the government maintains that value, or because two parties agree on said value. Fiat money was first introduced as an alternative to commodity-backed money.
Because fiat money is not linked to physical reserves, it risks becoming worthless due to hyperinflation. If people lose faith in a nation’s paper currency, like the U.S. dollar bill, the money will no longer hold any value. This differs from gold, which, historically, has been used in jewelry and decoration and has many modern economic uses including its use in the manufacture of electronic devices, computers and aerospace vehicles.
For the record, “fiat” is Latin for “let it be done.”
Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on the faith and credit of the economy.
Most modern paper currencies are fiat currencies; they have no intrinsic value and are used solely as a means of payment. Historically, governments would mint coins out of a physical commodity, such as gold or silver, or would print paper money that could be redeemed for a set amount of physical commodity.
Fiat money is inconvertible and cannot be redeemed. Fiat money rose to prominence in the 20th century, specifically after the collapse of the Bretton Woods Agreement, which was dissolved between 1968 and 1973, when the United States ceased to allow the conversion of the dollar into gold.
The U.S. Dollar as Fiat Money
The U.S. dollar is considered to be both fiat money and legal tender. Legal tender is any currency that a government declares to be legal. Many governments issue a fiat currency, then make it legal tender by setting it as the standard for debt repayment.
U.S dollars are now backed by the U.S. government — making it fiat money — and, as legal tender, is accepted for both private and public debts. After 1933, the federal government stopped allowing citizens to exchange currency for government gold in 1933. The gold standard, which backed U.S. currency with federal gold, ended completely in 1973 when the United States also stopped issuing gold to foreign governments in exchange for U.S. currency notes.
The value of the dollar fluctuates with economic conditions and the way interest rates are managed by the federal government. Since the money supply is controlled by the government, more dollars can be printed to create higher inflation as needed to influence economic conditions. As changes in public confidence in the U.S. government occur frequently, the value of the dollar may change rapidly even without ongoing federal management.
Advantages and Disadvantages of Fiat Money
Fiat money serves as a good currency if it can handle the roles that an economy needs of its monetary unit: storing value, providing a numerical account and facilitating exchange. Fiat currencies gained prominence in the 20th century when governments and central banks sought to alleviate their economies from the natural booms and busts of the business cycle. Because fiat money is not a scarce or fixed resource like gold, central banks have much greater control over its supply, which gives them the power to manage economic variables such as credit supply, liquidity, interest rates and money velocity. For instance, the U.S. Federal Reserve has the dual mandate to keep unemployment and inflation low.
Many throughout the economy had thought central banks had removed the threat of depressions or serious recessions, but the mortgage crisis of 2007 and subsequent financial meltdown quickly tempered this belief. A currency tied to gold is generally more stable than fiat money due to the limited supply of gold. There are more opportunities for the creation of bubbles with a fiat money due to its unlimited supply.
Losing Faith in a Fiat Currency
Fiat currencies are considered far more stable than commodity-backed currencies. That’s because the value of a commodity is based on its stability, and its price will tend to fluctuate based on its physical reserves.
So is it possible for the public to lose faith in its nation’s (fiat) currency? It can happen. One only needs to look at Zimbabwe, the Southern African country whose own currency was ruined by hyperinflation.
Economic conditions under the country’s president, Robert Mugabe, were deteriorating in the 1990s, with a low standard of living, high unemployment, lower wages and inflation as high as 17 percent at one point. In 2000, Mugabe began a series of “land reform programs,” which sought to take farms from the white minority and hand them over to black residents. Unfortunately, the farms were given to people who lacked experience in agriculture. This hit the country’s export revenue as these farms started to fail. In order to respond to the shortfall, the country’s central bank started to print money at a much more rapid pace, instead of trying to implement more traditional forms of economic policy. The money printed was used to help pay off the country’s debts, and offset higher prices set off by the agricultural industry’s failure.
As the economy continued to fall, inflation hit record rates, at one point hitting between 230 and 500 billion percent in 2008. Prices were rising rapidly and consumers were forced to carry bags of money just to purchase basic staples. This meant the value of the Zimbabwe dollar began to crumble. At the height of the decline, 1 trillion Zimbabwe dollars were worth about $0.40 USD. According to an NBC report, 100 trillion Zimbabwe dollar notes were the last banknote to be produced, and paid for a one-week commute to work.
The currency had to be scrapped altogether and was ultimately replaced by the U.S. dollar in 2009.