Loading the player...

What is 'Fiat Money'

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 that the money is made of. 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.

BREAKING DOWN 'Fiat Money'

Fiat is the Latin word for "it shall be."

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.

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 system in 1971, when the United States ceased to allow the conversion of the dollar into gold.

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.

RELATED TERMS
  1. Giuseppe Morchio

    An Italian executive who became CEO of Italian automaker Fiat ...
  2. Electronic Money

    Electronic money is money which exists only in banking computer ...
  3. Monetary Reserve

    A nation's assets held in a foreign currency and/or commodities ...
  4. Digital Currency Exchanger - DCE

    A market maker who exchanges legal tender for electronic currency, ...
  5. Store Of Value

    Any form of commodity, asset, or money that has value and can ...
  6. Federal Reserve Note

    The most accurate term used to describe the paper currency (dollar ...
Related Articles
  1. Tech

    Why Governments Are Afraid Of Bitcoin

    Bitcoin is the first decentralized peer-to-peer payment network and cryptocurrency. Governments may fear Bitcoin because its value is determined by users and not central governments or banks. ...
  2. Investing

    Starbucks and Fiat May Owe $34m Each in Back Taxes

    Wednesday's decision by European Commissioner for Competition Margrethe Vestager may curb, if not ultimately put an end to, maneuvers such as the "double Irish with a Dutch sandwich."
  3. Investing

    Why Gold Is No Longer the Currency King

    Although a gold standard seems like a good idea, looking at its role in U.S. history reveals that it may not be the beacon of stability that it claims.
  4. Insights

    How Currency Works

    Currency offers key advantages over economies based on direct trade. It provides sellers with a broader market for their goods and services. It is also a durable asset for people to accumulate ...
  5. Taxes

    The Link Between The Fed, Money, Debt And Taxes

    Assets on the Fed's balance sheet, money supply level, national debt level and economic production should be maintained in equilibrium.
  6. Investing

    Auto Sales Slump In January

    GM, Ford, and Fiat Chrysler see a slow start to 2017.
  7. Insights

    The Go-To Currency In 50 Years

    Discover why the euro will likely become heir to the currency throne.
  8. Investing

    3 Low Price-to-Book Ratio Stocks to Consider in 2016 (NWS, FCAU)

    These three stocks with low price-to-book ratios have promising prospects of turnarounds and improvements in operating metrics.
  9. Investing

    The Midas Touch For Gold Investors

    Find some golden opportunities by investing in gold commodities or futures contracts.
RELATED FAQS
  1. Is all paper money fiat money?

    Learn how the United States has converted from a gold-backed money system to a fiat one. Learn what is considered fiat money ... Read Answer >>
  2. Is fiat money more prone to inflation than commodity money?

    Learn more about commodity and fiat money and some of the differences between them. Find out when the U.S. abolished the ... Read Answer >>
  3. What is the difference between fiat money and legal tender?

    Learn more about fiat currency and legal tender. Find out how these terms are used by economists to describe different types ... Read Answer >>
  4. What is the gold standard?

    The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold, but ... Read Answer >>
  5. How do central banks inject money into the economy?

    Central banks use several different methods to increase (or decrease) the amount of money in the banking system. These actions ... Read Answer >>
  6. How is money supply used in monetary policy?

    Learn about the three components of the Federal Reserve's monetary policy. Understand how these three components use the ... Read Answer >>
Hot Definitions
  1. Risk-Return Tradeoff

    The principle that potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with ...
  2. Racketeering

    A fraudulent service built to serve a problem that wouldn't otherwise exist without the influence of the enterprise offering ...
  3. Aggregate Demand

    The total amount of goods and services demanded in the economy at a given overall price level and in a given time period.
  4. Fixed Cost

    A cost that does not change with an increase or decrease in the amount of goods or services produced. Fixed costs are expenses ...
  5. Blue Chip

    A blue chip is a nationally recognized, well-established, and financially sound company.
  6. Payback Period

    The length of time required to recover the cost of an investment. The payback period of a given investment or project is ...
Trading Center