What Is Fiat Money?

Fiat money differs from representative money, which is backed by a physical commodity such as gold or silver. Representative money represents a claim on a commodity that can be redeemed on demand, while fiat money has value primarily because of government regulation or law.¹

The shift from representative money to fiat money allows for greater flexibility in managing the economy but relies heavily on public trust in the issuing authority.

Prominent examples of fiat money include the U.S. dollar, the euro, and the British pound. These currencies are essential for daily transactions, savings, and international trade and investment benchmarks. Fiat money is a basic principle of the modern economy because it:

• Enables the exchange of goods and services without the limitations and complexities associated with barter systems or commodity money.
• Allows governments to exert significant economic control through monetary policy, affecting inflation, employment, and interest rates.
• Offers flexibility for central banks to implement policies to stabilize and grow the economy.

The history of fiat money dates back to ancient China during the Tang Dynasty, where it served as an alternative to heavy metal coins. The Chinese government found that issuing paper money, which they could control in supply, was far more efficient than minting coins.¹^,²

This concept spread slowly, but it wasn’t until the 20th century that fiat money became the global standard. The abandonment of the gold standard, particularly after President Richard Nixon’s decision in 1971, marked a significant shift towards fiat money systems worldwide, allowing for greater flexibility in monetary policy.¹,²

Fiat money significantly impacts the economy by facilitating trade and enabling the implementation of monetary policy. By controlling the money supply, governments can influence economic growth, manage inflation, and mitigate financial crises. However, reliance on trust and government stability means fiat money can be vulnerable to hyperinflation and financial collapse if that trust erodes.

Historical data indicates that fiat money systems have experienced periods of high inflation, such as the hyperinflation in Zimbabwe during the early 2000s, where annual inflation rates reached 89.7 sextillion percent in November 2008.³

In recent years, the M2 money supply, a broad measure of the amount of money circulating in the U.S. economy, has shown significant fluctuations, impacting inflation. During the COVID-19 pandemic, the M2 money supply grew at unprecedented rates due to the Federal Reserve’s efforts to stimulate the economy.⁴^,⁵

This rapid increase was followed by a notable decline starting in late 2022 as the Fed tightened monetary policy to combat rising inflation. The relationship between M2 growth and inflation underscores the critical role fiat money plays in the economy: an expanded money supply can drive inflation, while reductions can help control it.⁴^,⁵

These dynamics highlight the balancing act central banks must perform to maintain economic stability and prevent excessive inflation or deflation.

Fiat money and cryptocurrency are practically opposites.

Cryptocurrencies:⁶^,⁷

• Are less susceptible to government policies and can be more volatile
• Operate on blockchain technology and are not governed by a single entity or central authority
• Have their value derived from technology, scarcity, and user trust (a digital hedge against inflation)
• Are not able to be represented in any physical form or tender (but you can have a crypto savings account)

Fiat currencies:⁶^,⁷

• Are issued and controlled by governments and central banks
• Value depends on government trust
• Can be printed at any time, and there is no limit on their supply
• Can be represented by physical bills and coins

Fiat money is crucial in personal finance, influencing everything from savings and investments to loans and mortgages. For example, knowing that a government’s decision to print more money can lead to inflation may influence someone’s choice to hold savings in cash or make smart investments that may appreciate over time.

Staying informed about monetary policy changes, inflation rates, and the economic outlook can help people improve their finances with an understanding of fiat money. Diversifying investments and savings strategies can also protect against potential losses due to inflation or devaluation.