What Is Fiat Currency? Definition Plus How Fiat Money Works
Fiat currency is money that is not backed by a physical commodity, but rather by the government that issued it. The term comes from the Latin phrase “let it be done,” which is where the government’s power to declare a currency legal tender originates. Fiat money is what most countries have today- money that is produced and regulated by the government. Understanding what fiat currency is, how it works, and why it’s important is necessary to understanding the global economy.
Definition of Fiat Currency
Fiat currency is money, issued and backed by a country’s government, and which is accepted as legal tender, but which is not backed by an underlying tangible commodity. Fiat money has value based solely on supply and demand, and it is accepted as a form of payment because people are willing to accept it in exchange for goods and services. The government’s authority to declare a currency legal tender is what gives fiat money its value. That is, if the currency is declared legal tender by the government, it will be accepted in markets without any need for exchange for other commodities or currencies.
How Does Fiat Money Work?
Fiat money is different from other forms of currency in that its value is defined by the issuing government, not by the value of a physical commodity like gold or silver. Because of this, fiat money’s value is subject to inflation or deflation depending on the Health of a country’s economy. When a country’s economy is healthy, more money is produced to stimulate economic activities, resulting in a decrease in the value of the currency. On the other hand, when a country’s economy is struggling, less money is produced, resulting in an increase in the value of the currency.
The process of creating the money begins with the government. It either creates physical money (coins, bills) or finances a bank to create it. When a bank creates the money, it issues a loan to a borrower. This creates what’s called base money. Banks then can use this base money to create additional money through a process called fractional reserve banking.
What Is Fractional Reserve Banking?
Fractional reserve banking is when banks do not hold all the money deposited from customers in reserves. Instead, they hold only a fraction of the total deposits and lend out the remaining amount as loans. When a loan is issued, the borrower gets the money as a deposit in their bank account and the bank gets a promise of repayment. So, when a customer deposits money in the bank, it creates more money in the economy, as the bank can turn around and lend out the same money to another customer.
The issuance of these loans creates more money in the economy, which can increase the supply of money and drive up prices which can cause inflation. To prevent this, the central bank (the entity responsible for issuing currency) will monitor the amount of money being issued through fractional reserve banking and increase/decrease the interest rate as needed to maintain a stable price level.
Advantages of Fiat Money
Fiat money has many advantages over other forms of money such as gold and silver coins. These advantages include:
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Advantability of Use: Fiat money is globally accepted as a form of payment due to its uniformity and consistency in value. This makes it easier to use than other forms of money, as its value is readily accepted.
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Easily Managed: Fiat money is easier to manage than other types of money as its value is regulated by the issuing government. This means that the government can easily increase or decrease the quantity of money in circulation in order to keep a steady price level.
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Fluctuation Controllable: With fiat money, it is much easier to control the value of the currency, as the government can intervene to increase or decrease the money supply. By doing this, governments can help to control inflation and deflation.
Disadvantages of Fiat Money
Despite its advantages, fiat money also has some disadvantages. These include:
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Loss of Value Over Time: Fiat money can lose its value over time due to inflation, as the government may increase the money supply to stimulate the economy.
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Manipulation by Governments: Governments can manipulate the value of a currency by increasing or decreasing the money supply, which can lead to instability.
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Difficulty When Converting to Other Currencies: With fiat money, it can be more difficult to convert to other currencies than with other forms of money such as gold coins.
Fiat currency is a form of money that is created and regulated by the government, and which is accepted as a form of legal tender. Although fiat money has a number of advantages such as being widely accepted and easier to manage, it also has its drawbacks such as the potential for inflation and manipulation by governments. Despite this, it is still widely used as a form of payment around the world. Understanding how fiat money works and its implications is important for anyone interested in the global economy.
