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. Lawful Money

    Any form of currency issued by the United States Treasury and ...
  2. Giuseppe Morchio

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

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

    A nation's assets held in a foreign currency and/or commodities ...
  5. Gold Standard

    A monetary system in which a country's government allows its ...
  6. Digital Currency Exchanger - DCE

    A market maker who exchanges legal tender for electronic currency, ...
Related Articles
  1. Investing

    What is Fiat Money?

    Fiat money is currency that a government has declared to be legal tender, but is not backed by a physical commodity.
  2. Investing

    How Gold Affects Currencies

    There is a strong correlation between gold's value and the strength of currencies trading on foreign exchanges.
  3. Insights

    What is Money?

    Money: It's a part of everyone's life, and we all want it, but do you know how it gains value and how it is created?
  4. Insights

    Top 7 Companies Owned by Chrysler (FCAU)

    Despite a strong portfolio of operating units and historic automotive brand names, Fiat Chrysler Automobiles is still struggling to remain competitive.
  5. 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. ...
  6. Investing

    Will the Yuan Become an International Reserve Currency?

    Although still a matter of when, China is likely to reach a significant milestone when the International Monetary Fund decides to include the Chinese yuan in its special drawing rights basket ...
  7. 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.
  8. 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 ...
  9. 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.
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 representative money?

    Learn the main differences between fiat money and representative money. Differences include actual physical currency and ... Read Answer >>
  4. 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 >>
  5. Is credit a form of fiat money?

    Discover what fiat money is, learn how it developed historically into its use in most modern economies, and explore its relationship ... Read Answer >>
  6. 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 >>
Hot Definitions
  1. Free Rider Problem

    1. In economics, the free rider problem refers to a situation where some individuals in a population either consume more ...
  2. Dumping

    In international trade, the export by a country or company of a product at a price that is lower in the foreign market than ...
  3. Tender Offer

    An offer to purchase some or all of shareholders' shares in a corporation. The price offered is usually at a premium to the ...
  4. Ponzi Scheme

    A fraudulent investing scam promising high rates of return with little risk to investors. The Ponzi scheme generates returns ...
  5. Dow Jones Industrial Average - DJIA

    The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange ...
  6. Revolving Credit

    A line of credit where the customer pays a commitment fee and is then allowed to use the funds when they are needed. It is ...
Trading Center