Fiat vs. Representative Money: An Overview
Fiat money is physical money—paper money and coins—while representative money is something that represents the intent to pay such as a check.
Both fiat and representative money are backed by something. Without any backing, they would be completely worthless. Fiat money is backed by the government, while representative money can be backed by any number of things. For example, a personal check is backed by the money in a bank account.
Fiat money is one that is declared legal tender. This includes any form of currency in circulation such as paper money or coins. Fiat money is backed by a country's government instead of a physical commodity.
The value of fiat money is not determined by the material with which it is made. That means the metals used to mint coins and the paper used for bills are not valuable themselves. The value of the money, however, is determined by the government. It retains its value through government stability and that of the nation's economy.
Most coin and paper currencies that are used throughout the world are fiat money. This includes the U.S. dollar, the British pound, the Indian rupee, and the euro.
Fiat money became the norm after U.S. President Richard Nixon decided to abandon the gold standard in 1971. By doing so, he announced that the dollar was no longer convertible into gold. But because it can no longer be converted into gold and is not directly tied to the amount of gold a government stores, fiat money is at risk from inflation, meaning it can lose its value in the face of economic uncertainty. If too much money is printed by a government, the value of its currency will drop.
That was the case in Zimbabwe. Hyperinflation—extremely fast and out-of-control inflation—caused the currency to lose its value, and the government began printing banknotes with higher values in order to keep up with inflation. The country's central bank had to stop printing money, with the Zimbabwe dollar officially losing value in the foreign currency market. The country eventually turned to the U.S. dollar as its base currency.
Representative money is, unlike fiat money, government-produced money backed by a physical commodity such as precious metals. Other forms of representative money are still in place, including financial instruments like checks and credit cards. These forms of payment are used today in place of traditional money, with the intent to pay at a later date.
Representative money has a long history. In the 17th and early 18th centuries, furs and commodities like corn were used in transactions. This was followed by precious metals like gold and silver. Up until 1970, the world followed the gold standard, where a person was able to exchange the money they held directly for gold. A country that followed the gold standard set a fixed price for gold, buying and selling gold at that price. That fixed price was used to determine the value of the currency. So if Britain set the price of gold at £500 an ounce, the value of the dollar would be 1/500th of an ounce of gold.
[Important: The major appeal for representative money was that it was not influenced by inflation; governments were only able to print enough money for the amount of gold they held in their vaults.]
The United States severed its ties with the gold standard in 1971, turning its currency into fiat money. That led all national currencies to be valued against the U.S. dollar. Instead of using gold as the power behind the money, the government is the strength and the reason the fiat money has value. The money has value because the government says it does. In turn, people want the fiat money. If the government fell on hard times, or if people everywhere suddenly did not want a form of currency such as the U.S. dollar, it would lose all of its value because there is no physical gold behind it.
But many governments fall to the lure of printing too much paper money, which leads to inflation. A dollar is no longer worth a dollar in gold. When this happens, the money becomes fiat money.
- Fiat money is physical money backed by a government and is considered legal tender.
- Representative money is backed by a physical commodity such as precious metals or instruments like checks and credit cards.
- Prior to 1971, the world's currencies were representative, backed by gold.
- Fiat money is subject to the effects of inflation, during which time it may lose its value in the global markets.