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Fiat vs Representative Money: What’s the Difference?

15 August 2023
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what is fiat money backed by

With a fiat currency, the money supply can be increased far more easily as demand increases, helping to stabilize a currency’s spending power and preventing deflation, or the falling price of goods. If the U.S. and other nations had remained on a gold standard, the world’s supply of money would be limited to the available gold. And while the amount of gold on earth hasn’t increased much over billions of years, the human population, its economic output, and the demand for money certainly have gone up. The African nation of Zimbabwe provided an example of the worst-case scenario in the early 2000s. In response to serious economic problems, the country’s central bank began to print money at a staggering pace, resulting in hyperinflation. Bitcoins and other cyber currencies are not backed by any government or other authority and are not fiat currencies.

what is fiat money backed by

The most notable currency not included in this table is the Chinese yuan, for which the statistics are listed as “not available”. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. The cryptocurrencies on the strongest, most secure, and most capable blockchain networks could grow more valuable for another important reason, too — the innovation in uses happening on the blockchain.

Why Is It Called Fiat Currency?

The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it. Commodity-based currencies were volatile due to the regular business cycle and periodic recessions. The central banks can print or hold paper money as they may need, giving them greater control over the money supply, interest rates, and liquidity. For example, the Federal Reserve’s control over the money supply and demand enabled it to manage the Global Financial Crisis of 2008 from causing greater harm to the U.S. financial system and global economy. The value of fiat money depends on supply and demand and was introduced as an alternative to commodity money and representative money.

The number of dollars printed was no longer directly tied to the amount of gold the government stored. Prices rose rapidly and consumers carried bags full of money just to purchase basic staples. At the height of the crisis, the government of Zimbabwe was forced to issue a 100-trillion Zimbabwean dollar note. Eventually, foreign currencies were used more widely than the Zimbabwean dollar. The term “fiat” is a Latin word that is often translated as “it shall be” or “let it be done.” Thus fiat currencies only have value because the government maintains that value; there is no utility to fiat money in itself.

what is fiat money backed by

A more recent example is the currency instability in Venezuela that began in 2016 during the country’s ongoing socioeconomic and political crisis. American colonies, France, and the Continental Congress started issuing bills of credit that were used to make payments. The provincial governments issued notes that the holders would use to pay taxes to the authorities.

Examples of Fiat Money

And, as we have seen over the past several years as many have gained immensely in value, they can hedge your wealth against inflation. Increasing the money supply may sound like a central bank, such as the U.S. Federal Reserve Board, can just magically make money appear out of thin air. The Fed doesn’t so much create money out of thin air as exchange newly made money for an asset, such as a loan to a bank, a U.S.

Often nations would have dual currencies, with paper trading at some discount to money which represented specie. The Bretton Woods Agreement fixed the value of one troy ounce of gold to 35 United States Dollars. However, in 1971, United States President, Richard Nixon, introduced a series of economic measures including canceling the direct convertibility of dollars into gold due to declining gold reserves. Since then, most countries have adopted fiat monies that are exchangeable between major currencies.

  1. The use of fiat money became popular in the 20th century as governments and banks moved in to protect their economies from the frequent busts of the business cycle.
  2. In this sense, U.S. dollars are now “legal tender,” rather than “lawful money,” which can be exchanged for gold, silver, or any other commodity.
  3. And there you have an example of the first advantage of fiat currency — being able to manage the money supply to make sure there’s enough to prevent economy-crashing deflation.
  4. Since the end of the Bretton Woods system in 1971, the major currencies in the world are fiat money.
  5. Some examples of this are the Zimbabwean dollar, China’s money during 1945 and the Weimar Republic’s mark during 1923.

Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies. Fiat money has been the dominant form of currency since the United States, and then the rest of the world, dropped the gold standard in the 1970s. That is, the cash has the value that a government attaches to it and does not represent a store of equal value, such as gold. This is not determined by the worth of the material that is used to produce it, and it is not backed by a commodity of equal value. It has the value that the government says it has, whether that is a nickel or $100.

Fiat vs. Representative Money: What’s the Difference?

The issuing of too many bills of credit generated some controversy due to the dangers of inflation. Fiat money is a currency that lacks intrinsic value and is established as a legal tender by government regulation. Traditionally, currencies were backed by physical commodities such as silver and gold, but fiat money is based on the creditworthiness of the issuing government. Fiat money derives its value from supply and demand, not an underlying physical commodity.

Fiat vs. Representative Money: An Overview

The most important feature of fiat money is the stability of its value, unlike commodity-based money like gold, copper, and silver. The use of fiat money became popular in the 20th century as governments and banks moved in to protect their economies from the frequent busts of the business cycle. A fiat currency functions well when the public has enough confidence in the currency’s ability to act as a storage medium for purchasing power.

It is backed by a deposit of cash or some other commodity that is stored by the payer and ready to be handed over to the payee. Although they have no physical existence, they can be exchanged for other commodities and currencies. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer. The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on, top-rated podcasts, and non-profit The Motley Fool Foundation. Other theories of money, such as the credit theory, suggest that since all money is a credit-debt relation, it does not matter if money is backed by anything to maintain value.

The value of fiat money is not determined by the material with which it is made. The metals used to mint coins and the paper used for bills are not valuable in themselves. The succeeding Yuan Dynasty was the first dynasty of China to use paper currency as the predominant circulating medium. The founder of the Yuan Dynasty, Kublai Khan, issued paper money known as Jiaochao during his reign. The original notes during the Yuan Dynasty were restricted in area and duration as in the Song Dynasty.

Even though the Federal Reserve controls the money supply, it was not able to prevent the crisis from happening. Critics of fiat money argue that the limited supply of gold makes it a more stable currency than fiat money, which has an unlimited supply. Fiat currency, also called fiat money, is legal tender whose value is backed by the government that issued it.

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