Fiat money has value because the government has declared that it does. This kind of money has no intrinsic value, but since a government supports it, fiat currency can be exchanged for goods and services. Let's now look at exactly what fiat money is, how it can be used, and its benefits and downfalls.
Money comes in many different forms. However, anything that is used as money needs to fulfill certain basic requirements:
Money is a medium of exchange, meaning that people can exchange it for goods and services
Money is a store of value, meaning that people can save it so they can exchange later
Money is a unit of account, meaning that it can be used to measure something's value
Traditionally, many currencies derived their value from commodities like gold and silver. The U.S. dollar, for example, had a fixed exchange rate relative to gold as a result of the Bretton Woods agreement. Under this system, one troy ounce of gold was worth US$35.
This agreement, which provided a relatively firm basis for the value of the U.S. dollar, lasted between 1944 and 1973, when President Nixon eliminated any peg between the greenback and gold. President Nixon began lowering the U.S. dollar's value relative to the precious metal in response to harsh economic conditions, as the United States was struggling with both recession and high inflation.
Unfortunately, many people started trading their U.S. dollars for gold, which prompted President Nixon to eliminate the fixed exchange rate that existed between the fiat currency and the precious metal. The price of gold skyrocketed, quickly climbing to US$120.
What Is Fiat Money?
Fiat money is different from a commodity-backed currency because it gets its power from government decrees and the faith of those who use it. Several variables contribute to the value of an individual fiat currency, including the economic strength of the nation whose government is backing that currency, as well as the policies of that government and how these two factors influence interest rates.
For people to use a fiat currency, they must consider it to be both stable and usable. Crucially, they need to have faith in the ability of the issuing government to support that particular form of money. Because people trust in fiat currencies, they can be used to purchase goods and services, which in turn prevents users from having to resort to barter. In addition to enabling basic economic commerce, fiat currency makes more advanced activities possible.
For example, entrepreneurs can use fiat currencies to hire new employees, purchase capital equipment and venture into new regions. Without fiat currency, they would need to pay for all this in some other manner, which could be complicated and difficult.
Benefits Of Fiat Money
There are several distinct benefits to using fiat money. These perks include:
One major benefit of fiat currency is that it offers relative stability. If necessary, central banks can control the money supply by holding or printing paper money. This situation can be greatly preferable to tying a currency to commodities, which can experience significant price fluctuations based on the business cycle.
Placing a currency under the authority of a central bank not only helps provide stability, but it also grants the government that controls that central bank greater ability to respond to changing economic conditions. The U.S. Federal Reserve (Fed), for example, can respond to adverse conditions by changing the discount rate, altering the reserve requirements of banks and engaging in open-market operations. By leveraging these tools, the Fed can increase or decrease the money supply, as well as influence the interest rates that can have a significant impact on economic activity.
Printing bills requires far less time and energy than mining, storing and protecting commodities like gold and silver. Raw materials like gold are finite in nature, meaning that their supply is fixed. A country relying on this precious metal could encounter problems if it ran out of gold to mine. Governments using fiat currency, however, do not face these problems.
Downsides Of Fiat Money
Fiat money also has its drawbacks. These downsides include:
Concentration Of Power
There are concerns that relying on fiat currencies places too much power in the hands of a central bank. Concentrating that control in one place could potentially cause doubts for many people, including those both inside and outside the nation where the central bank is located.
Lack of Concrete Value
Fiat currencies lack intrinsic value. The problem with this is that if a central bank decided to print substantial amounts of currency, this would then cause substantial inflation.
Fiat money has value because the government has decreed that it does. While it lacks any intrinsic value, this kind of money can be exchanged for goods and services, which helps form the basis of a functional economy.
Traditionally, money frequently got its value from commodities like gold and silver. However, this approach comes with significant limitations, such as the time, energy and expense associated with accumulating and storing the raw materials.
There are specific benefits associated with fiat currencies. Using them allows governments to retain control over the money supply and use policy to influence their value. Further, harnessing fiat money gives the governments of the world greater flexibility to respond to changing economic conditions.
Fiat currencies also have their downsides. They have no intrinsic value, for starters. Also, some have voiced their concerns about the potential implications of placing too much control in the hands of central banks, as this centralisation could spur high inflation or less-than-ideal economic conditions.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…