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The value of fiat money is determined by several factors, including economic supply and demand, interest rates, money supply and the stability of the issuing country. Virtually all countries today use fiat money as their accepted form of legal tender. Fiat money is currency backed by the public’s faith in the government or central bank that issued it.

Cons of a fiat currency

Laws ensure nothing other than official legal tender gains enough traction to be used as money in the economy. Notably, checks and credit cards aren’t legal tender—rather, they are money substitutes. It’s money that has value derived from the actual substance of the money or its use. Precious metals, salt, tobacco, barley, cocoa beans, and many other items have been used as commodity currencies in the past. The Subprime Mortgage Crisis of 2007 showed that the central bank can’t always control everything needed to fully protect the economy. So, when we say a currency backed by the government itself, that’s fiat money.

1. Governments are starting to study cryptocurrency and many experts believe that government-backed cryptocurrencies will arrive in the near future.
2. Fiat money comes in both physical forms — like banknotes and coins — and digital forms — such as bank credit.
3. Instead, it derives its value from people’s trust in the governments that issue it.
4. For instance, gold has historically held significant value due to its rarity – which is seen as a status symbol of power and wealth.

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Our writers and editors used an in-house natural language generation platform to assist with portions of this article, allowing them to focus on adding information that is uniquely helpful. The article was reviewed, fact-checked and edited by our editorial staff prior to publication. “Expert verified” means that our Financial Review Board thoroughly evaluated the article for accuracy and clarity.

Fiat Money vs Representative Money

By the late 20th century, it had become impossible for the United States to maintain gold at a fixed rate, and in August 1971, U.S. Within two years, most major currencies “floated,” rising https://www.1investing.in/ and falling in value against one another based on market demand. According to the quantity theory of inflation, excessive issuance of fiat money can lead to its depreciation in value.

Fiat money, conversely, derives its value from trust and legal decrees. Moreover, with digital transactions becoming the norm, fiat money effortlessly integrates into the technological landscape, hammer and hanging man ensuring seamless and efficient commerce. By being able to influence interest rates, manage inflation, and control money supply, governments can adapt to economic challenges swiftly.

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For example, a personal check is backed by the money in the issuer’s bank account. Fiat money is a currency that is declared money by decree—not by the marketplace. Though some fiat currencies were once backed by commodities, they are now only backed by the legislative power of the government issuing them. From there, governments began issuing paper currency, or notes that were redeemable for a measure of the backing standard. For the British pound sterling, the answer was actually gold, beginning in the 1700s.

It holds value, is easy to exchange, and the currency is countable. Plus, it’s cost-efficient to produce the currency — known as seigniorage. 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.

In many countries a central bank, like the Federal Reserve in the U.S., manages the money supply and the stability of fiat currency. Factors such as interest rates and market operations help control inflation and aid in maintaining the value of the currency. Basing government legal tender on gold and silver reserves became an issue as the population exploded, but there was no increase in the amount of gold or silver in government reserves. Building a strong economy was impossible if all the currency was tied to the stores of the commodity. Throughout history, paper money and banknotes had traditionally acted as promises to pay the bearer a specified amount of a precious metal, typically silver or gold.

In 17th century New France, now part of Canada, the universally accepted medium of exchange was the beaver pelt. As the colony expanded, coins from France came to be used widely, but there was usually a shortage of French coins. In 1685, the colonial authorities in New France found themselves seriously short of money. A military expedition against the Iroquois had gone badly and tax revenues were down, reducing government money reserves. Typically, when short of funds, the government would simply delay paying merchants for purchases, but it was not safe to delay payment to soldiers due to the risk of mutiny.

While too much of this practice leads to over inflation, just the right amount helps the economy grow in the long term. We could actually see fiat money become cryptocurrencies in the future, too. Many governments have begun studying digital currency, and a government-built and -backed cryptocurrency seems almost inevitable at some point. El Salvador adopted Bitcoin (BTC -0.2%) as legal tender in 2021. Fiat currency, also called fiat money, is legal tender whose value is backed by the government that issued it. This differs from money that is backed by some physical asset that sets the standard of its value, such as gold.

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