Fiat Currency - what is it?

Fiat Currency - what is it?
Table of Contents

In previous eras in human history, rather than the paper money that we are all accustomed to using today, individuals would exchange products and services for gold. In contrast, we no longer trade goods for gold but rather with other currencies such as the U.s Dollar, the euro, and even cryptocurrencies such as bitcoin.

There are many various kinds of currencies in use today; some, like fiat currencies, can be supported by a government, while others, like cryptocurrencies, are decentralized and backed by technology called blockchain. In this post, we will discuss the question “What is fiat currency?

What exactly is Fiat Currency

In the past, governments would mint or print money that was either made from a physical commodity — such as precious metals like gold or silver — or could be redeemed for an equivalent amount of that commodity. This practice eventually gave way to the creation of fiat money, which is not backed by any physical commodity. However, as time progressed, it became impractical for governments to store sufficient quantities of a precious metal to back each coin or piece of paper currency, and as a result, the use of currencies backed solely by the government, known as fiat currencies, became widespread.

For instance, the present currency system in the United States was developed during the 20th century when many nations moved away from the gold standard, which is a monetary system in which currencies are directly related to gold. This occurred in the United States. Since fiat currency cannot be redeemed for an underlying asset, its value is determined by the policies of the government and the markets for foreign currencies.

There are around 180 different fiat currencies in use throughout the world at the moment. The market forces of supply and demand are the primary drivers of the value of fiat currencies. Monetary policy is established by central banks such as the Federal Reserve in order to exercise control over the supply of money. These institutions determine how much cash the economy requires and then produce it appropriately. The most significant danger is that they may create too much money, which could set off a period of hyperinflation. Hyperinflation is characterized by sudden, out-of-control price rises that have the potential to cause chaos on the economy. The reliability of a government that issues a fiat currency and the credibility of the central bank that is responsible for managing the currency’s supply are both necessary components for people to have faith in the currency.

Check also: What is a “smart contract?”

How does Fiat currency works

Let’s use the dollar as an illustration of how fiat money works so we can better understand the concept. The Federal Reserve was established initially to protect banks against panics, but it has subsequently expanded its role to play a more significant role in the management of the economy.

The distribution of dollars is controlled by the Federal Reserve. The government charged it with lowering unemployment while maintaining a constant level of inflation as one of its primary objectives. It achieves this result by:

  • Buying more Treasurys from private dealers by increasing the quantity it purchases (buying them with new dollars that it creates)
  • lowering the interest rate that it offers to financial institutions on reserves that are kept at the Federal Reserve (encouraging banks to lend)
  • lowering the needed amount of cash reserves that financial institutions must hold on hand.

Some economists believe that fiat money does have value despite the fact that it does not have an intrinsic worth in the same way as commodity currencies do. They base their contention on the fact that governments demand taxes to be paid in the currency. If it is the only money that can be accepted legally for transactions, then it will have some kind of value. Legal tender regulations can also give a fiat currency value.

The value of fiat money, similar to the value of commodities, is determined by supply and demand. A decrease in the value of a fiat currency will occur if there is an excessive supply of that money. Prices tend to rise if the purchasing power of money decreases (inflation).

Read also: What is meant by stable coin?

Comparing fiat Money with Cryptocurrency

Fiat money is a form of legal tender, which is a currency that has been proclaimed to be legal tender by the government. The value of fiat money is supported by the issuer (the government). On the other hand, cryptocurrency is a form of digital money that is supported by blockchain technology and decentralized, which means that it is not backed by a central authority such as a government.

Cryptocurrency, in contrast to fiat money, is more vulnerable to price fluctuations and offers a better level of information security than fiat money does. Even if there are some people who believe that cryptocurrencies will one day replace fiat currencies, the majority of transactions that take place throughout the world currently use fiat money.

Check also: How to measure your ROI?

Benefits of Fiat Money

  • If fiat money can perform the functions that a country’s economy requires of its monetary unit—storing value, offering a numerical account, and enabling exchange—it is a sound currency.
  • Producing Fiat money is less expensive than producing a currency that is directly linked to a commodity.
  • Governments and central banks attempted to protect their economies from the worst impacts of the natural booms and busts of the economic cycle, which is in part why fiat currencies rose to popularity in the 20th century.
  • Central banks are better equipped to handle economic factors including credit supply, liquidity, interest rates, and money velocity since fiat money has a lot more supply control than precious metals like gold do.