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 from which the money is made.

BREAKING DOWN 'Fiat Money'

Fiat money only has value because the government maintains that value, or because two parties agree on said value. Fiat money was first introduced as an alternative to commodity-backed money.

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.

For the record, "fiat" is Latin for "let it be done."

History

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.

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 Agreement, which was dissolved between 1968 and 1973, when the United States ceased to allow the conversion of the dollar into gold.

The U.S. Dollar as Fiat Money

The U.S. dollar is considered to be both fiat money and legal tender. Legal tender is any currency that a government declares to be legal. Many governments issue a fiat currency, then make it legal tender by setting it as the standard for debt repayment.

U.S dollars are now backed by the U.S. government — making it fiat money — and, as legal tender, is accepted for both private and public debts. After 1933, the federal government stopped allowing citizens to exchange currency for government gold in 1933. The gold standard, which backed U.S. currency with federal gold, ended completely in 1973 when the United States also stopped issuing gold to foreign governments in exchange for U.S. currency notes. 

The value of the dollar fluctuates with economic conditions and the way interest rates are managed by the federal government. Since the money supply is controlled by the government, more dollars can be printed to create higher inflation as needed to influence economic conditions. As changes in public confidence in the U.S. government occur frequently, the value of the dollar may change rapidly even without ongoing federal management.

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.

Losing Faith in a Fiat Currency

Fiat currencies are considered far more stable than commodity-backed currencies. That's because the value of a commodity is based on its stability, and its price will tend to fluctuate based on its physical reserves. 

So is it possible for the public to lose faith in its nation's (fiat) currency? It can happen. One only needs to look at Zimbabwe, the Southern African country whose own currency was ruined by hyperinflation. 

Economic conditions under the country's president, Robert Mugabe, were deteriorating in the 1990s, with a low standard of living, high unemployment, lower wages and inflation as high as 17 percent at one point. In 2000, Mugabe began a series of "land reform programs," which sought to take farms from the white minority and hand them over to black residents. Unfortunately, the farms were given to people who lacked experience in agriculture. This hit the country's export revenue as these farms started to fail. In order to respond to the shortfall, the country's central bank started to print money at a much more rapid pace, instead of trying to implement more traditional forms of economic policy. The money printed was used to help pay off the country's debts, and offset higher prices set off by the agricultural industry's failure. 

As the economy continued to fall, inflation hit record rates, at one point hitting between 230 and 500 billion percent in 2008. Prices were rising rapidly and consumers were forced to carry bags of money just to purchase basic staples. This meant the value of the Zimbabwe dollar began to crumble. At the height of the decline, 1 trillion Zimbabwe dollars were worth about $0.40 USD. According to an NBC report, 100 trillion Zimbabwe dollar notes were the last banknote to be produced, and paid for a one-week commute to work. 

The currency had to be scrapped altogether and was ultimately replaced by the U.S. dollar in 2009. 

[ With the rise of cryptocurrencies, the discussion around fiat money has become much more prevalent among currency traders and economists alike. If you're looking to become more active in the cryptocurrency trading world, check out Investopedia Academy's Crypto Trading course. ]

RELATED TERMS
  1. Money

    Money is an officially issued legal tender, typically currency ...
  2. Private Currency

    A private currency is typically issued by a private firm or group ...
  3. Currency

    Currency is a generally accepted form of money, including coins ...
  4. Store Of Value

    Any form of commodity, asset, or money that has value and can ...
  5. National Currency

    A national currency is a legal tender issued by a central bank ...
  6. Banknote

    A banknote is a negotiable promissory note, which a bank can ...
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. Tech

    A Brief History of Cryptocurrency

    A brief history of cryptocurrency and some insight into how it works, why it has value, and whether it's a bubble or here to stay.
  4. Insights

    What is Money?

    Money: It's a part of everyone's life, and we all want it, but what is it, how does it gain value, and how it was created?
  5. Investing

    Ally Financial Could Take Hit If Fiat Launches Own Financing Service

    Ally Financial could take hit if Fiat Chrysler launches its own finance unit in the U.S.
  6. Tech

    Investing in Cryptocurrency: The Risks

    Do the rewards outweigh the risks when investing in a cryptocurrency like bitcoin?
  7. Trading

    How the U.S. Dollar Became the World's Reserve Currency

    The U.S. dollar was first minted in 1914. Find out what occurred during the last century to make the U.S. dollar the world's reserve currency.
  8. 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.
  9. Trading

    What Would It Take for the U.S. Dollar to Collapse?

    Quantitative easing raised concerns about the dollar's vulnerability, but a review of the dollar's strengths and weaknesses suggests that a currency crisis is unlikely.
RELATED FAQS
  1. 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 >>
  2. Is there a world currency? If so, what is it?

    There is no such thing as a world currency. However, since World War II, the dominant or reserve currency of the world has ... Read Answer >>
  3. How are international exchange rates set?

    Knowing the value of your home currency in relation to different foreign currencies helps investors to analyze investments ... Read Answer >>
  4. How does inflation affect the exchange rate between two nations?

    Countries attempt to balance interest rates and inflation, but the interrelationship between the two is complex and can influence ... Read Answer >>
Hot Definitions
  1. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  2. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  3. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  4. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  5. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  6. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
Trading Center