Definition and Characteristics
Fiat money, a form of currency designated as legal tender by government regulation, is not backed by a physical commodity such as gold or silver. It derives its value from the trust and confidence of the people who use it and is generally accepted as a medium of exchange and a unit of account. Unlike commodity money, which has intrinsic value due to its material composition, fiat money lacks inherent worth and relies solely on the faith in the issuing government.
Key Facts
- Definition: Fiat money is a government-issued currency that is designated as legal tender and is authorized by government regulation. It is not backed by a commodity and does not have intrinsic value.
- Control by Central Banks: Fiat money allows central banks to have greater control over the economy because they can control the supply of money by printing more or less of it. This control over the money supply is a key tool in monetary policy.
- Value and Acceptance: The value of fiat money is based on the trust and confidence of the people who use it. It is generally accepted as a medium of exchange and a unit of account because people believe it will be accepted by others in transactions.
- Creation of Money: Most of the money in the economy is created by commercial banks when they provide loans, rather than by printing presses at the central bank. When loans are repaid, the electronic money created by banks is effectively “deleted” from the system.
- Global Use: Since the end of the Bretton Woods system in 1971, most major currencies in the world have become fiat money. This means that they are not backed by a specific commodity and their value is determined by market forces.
Control by Central Banks
Fiat money provides central banks with significant control over the economy. By regulating the supply of money, central banks can influence economic variables such as credit supply, liquidity, interest rates, and money velocity. This control is a key tool in monetary policy, enabling central banks to pursue specific economic goals, such as maintaining price stability and promoting economic growth.
Value and Acceptance
The value of fiat money is primarily determined by supply and demand dynamics in the market. However, it is also influenced by factors such as the stability of the issuing government, economic conditions, and public confidence. Fiat money is generally accepted as a medium of exchange and a unit of account because people believe it will be accepted by others in transactions. This acceptance is crucial for the functioning of an economy, as it facilitates trade and enables the efficient allocation of resources.
Creation of Money
In modern economies, most of the money supply is created by commercial banks through the process of fractional reserve banking. When banks provide loans, they create new money electronically, expanding the total supply of money in circulation. This process is distinct from the traditional method of money creation by printing physical currency at the central bank. When loans are repaid, the electronic money created by banks is effectively “deleted” from the system, reducing the money supply.
Global Use and Implications
Since the collapse of the Bretton Woods system in 1971, most major currencies worldwide have become fiat money. This means that they are not backed by a specific commodity, and their value is determined by market forces. This shift to fiat money has significant implications for global trade and finance, as it allows governments and central banks to pursue independent monetary policies and respond to economic conditions in their respective countries.
References
- Investopedia: Fiat Money: What It Is, How It Works, Example, Pros & Cons
- Wikipedia: Fiat money
- Britannica: Fiat money
FAQs
What is fiat money?
Fiat money is a government-issued currency that is not backed by a physical commodity such as gold or silver. Its value is derived from the trust and confidence of the people who use it and is generally accepted as a medium of exchange and a unit of account.
How does fiat money differ from commodity money?
Unlike fiat money, commodity money has intrinsic value due to its material composition. Its value is determined by the value of the commodity it is made of, such as gold or silver. Fiat money, on the other hand, lacks inherent worth and relies solely on the faith in the issuing government.
Who controls the supply of fiat money?
Central banks are responsible for controlling the supply of fiat money. They can increase or decrease the money supply through various monetary policy tools, such as adjusting interest rates and conducting open market operations.
How is fiat money created?
In modern economies, most fiat money is created by commercial banks through fractional reserve banking. When banks provide loans, they create new money electronically, expanding the total money supply in circulation.
What factors determine the value of fiat money?
The value of fiat money is primarily determined by supply and demand dynamics in the market. However, it is also influenced by factors such as the stability of the issuing government, economic conditions, and public confidence.
What are the advantages of fiat money?
Fiat money provides central banks with greater control over the economy, allowing them to pursue specific economic goals. It is also cost-efficient to produce and facilitates trade and economic activity by serving as a medium of exchange and a unit of account.
What are the disadvantages of fiat money?
Fiat money is susceptible to inflation and hyperinflation if the government prints too much money. It can also lead to the creation of bubbles and financial instability due to its unlimited supply.
What are some examples of fiat money?
Examples of fiat money include the US dollar, the euro, the British pound, the Japanese yen, and the Indian rupee. These currencies are not backed by a physical commodity and their value is determined by market forces.