Fiat vs. Representative Money: An Overview
Fiat money is physical money—both paper money and coins—while representative money is a form of currency 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 a government, while representative money can be backed by different assets or financial instruments. For example, a personal check is backed by the money in a bank account.
- Fiat money is both physical money and legal tender and is backed by a nation's government.
- Representative money is backed by a physical commodity such as precious metals or instruments such as checks and credit cards.
- Fiat money can be used to buy goods and services because both parties involved in a transaction agree on the currency's value.
- Before 1971, the world's currencies were representative and backed by gold.
- Fiat money is subject to the effects of inflation, during which time it may lose its value in the global markets.
What Is Fiat Money?
Fiat money is a form of currency that is declared legal tender. This includes money in circulation such as paper money or coins. Fiat money is backed by a country's government instead of a physical commodity or financial instrument. This means 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.
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. Rather, the value of the money is determined by the government. It retains its value through government stability and that of the nation's economy.
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. 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. This means it can lose its value in the face of economic uncertainty. If the government prints too much money, the value of its currency drops.
That was the case in Zimbabwe. Hyperinflation—extremely fast and out-of-control inflation—caused the currency to lose its value. The government began printing banknotes with higher values to keep up with inflation. The country's central bank had to stop printing money, causing the Zimbabwe dollar to officially lose value in the foreign currency market. The country eventually turned to the U.S. dollar as its base currency.
What Is Representative Money?
Representative money is 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 such as 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.
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.
Key Differences Between Fiat and Representative Money
While fiat money doesn't have intrinsic value—through an objective calculation—its value is set by the government that issues the currency. Most modern currencies around the world are forms of fiat money. Fiat money can be used to buy goods and services because both parties involved in a transaction agree on the currency's value.
Representative money, on the other hand, is valued based on the instrument backing it, whether that's a commodity, asset, or another financial instrument such as a check. A single dollar may, for instance, be worth a specific amount of gold. Most currencies are no longer backed by commodities. But there are still other forms of representative money, such as checks, money orders, and bank drafts. They can be exchanged for the value listed on the instrument.
As mentioned, the U.S. 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 fiat money has value. The money has value because the government says it does. In turn, people want to have fiat money.
If the government falls 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 end up 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.
What Advantages Does Fiat Money Have Over Representative Money?
Fiat money is a form of currency that is backed by a country's government. As such, this form of money retains its value through the stability of the government and the national economy.
Does Fiat Money Have Value?
Yes, fiat money does have value. Its value is determined by the government, not by the material from which it is produced or backed.
Why Is It Called Fiat Currency?
The term is derived from the Latin word fiat, which means a determination by authority—in this case, it's the government that decrees the value of the currency and it isn't representative of another asset or financial instrument such as gold or a check.
Is Bitcoin a Fiat Currency?
Bitcoins aren't backed by commodities, so they're not necessarily a form of representative currency. They are, though, backed by the faith of investors and—to some degree—governments, so they may be considered a form of fiat currency.