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 Latin for "let it be done."

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. Private Currency

    Units of value issued by private companies or organizations. ...
  2. Cash

    Cash is legal tender or coins that can be used to exchange goods, ...
  3. Money Supply

    The entire stock of currency and other liquid instruments in ...
  4. Currency

    Currency is a generally accepted form of money, including coins ...
  5. Reserve Currency

    A reserve currency is held by central banks and other major financial ...
  6. Money

    Money is an officially-issued legal tender, typically currency ...
Related Articles
  1. Insights

    Top 7 Companies Owned by Fiat Chrysler (FCAU)

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

    The Midas Touch For Gold Investors

    Find some golden opportunities by investing in gold commodities or futures contracts.
  5. Insights

    Fiat Chrysler Might Shed Magneti Marelli (FCAU)

    If you read between the lines, then something might be in the works with Samsung.
  6. Investing

    Why is Gold a Counter Cyclical Asset?

    Gold is widely considered a safe haven during market turbulence. History has proven gold performs counter cyclically to the state of the U.S. economy.
  7. Investing

    The Most Affordable Way to Buy Gold: Physical Gold or ETFs?

    Investing in gold has never been easier than it is today. Check out this article to learn more about gold ETFs and other ways that you can add gold to your portfolio.
  8. Trading

    Forex: World's Biggest Market A Relative Newcomer

    Unlike the stock markets, the forex market is a truly new market. We’ll take a brief look at its origins and how it works today.
  9. Personal Finance

    Currency Principle vs. Banking Principle: How Different?

    Understanding the difference between the currency principle and the banking principle helps to illustrate the most basic functions of money.
  10. Insights

    Is U.S. Inflation on the Horizon?

    Inflation, or the general price level of all goods and services in an economy, has remained subdued in the years following the Great Recession. Given recent developments, is the U.S. on the verge ...
RELATED FAQS
  1. 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 >>
  2. What are key economic factors that can cause currency depreciation in a country?

    Read about the causes of currency devaluation, and find out how to differentiate between relative and absolute currency devaluation. Read Answer >>
  3. What precise measures are implemented in most monetary policies?

    Read about some of the precise measures implemented in most monetary policies, and learn why monetary policy is considered ... Read Answer >>
  4. What countries have the largest gold reserves?

    Find out which countries have the largest gold reserve stockpiles, and learn why governments still feel that it's necessary ... Read Answer >>
  5. Who decides when to print money in the U.S.?

    Learn who decides to print money in the United States. Many people relate credit creation, which is the Fed's job, with printing ... Read Answer >>
Hot Definitions
  1. Intrinsic Value

    Intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including ...
  2. Bubble

    1. An economic cycle characterized by rapid expansion followed by a contraction. 2. A surge in equity prices, often more ...
  3. Swap

    A swap is a derivative contract through which two parties exchange financial instruments, such as interest rates, commodities, ...
  4. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  5. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  6. Risk Tolerance

    The degree of variability in investment returns that an individual is willing to withstand. Risk tolerance is an important ...
Trading Center