Explained: What is fiat currency?

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What is fiat currency? What are some of the prominent examples of fiat currency? In this article, we are taking a deep dive into how fiat currency works and compares to cryptocurrencies.

Introduction to fiat currency

To understand why some people believe that cryptocurrencies can be used instead of fiat money, we should first understand what fiat money is.

Fiat money is a currency regulated and established as a medium of exchange by governments. Unlike cryptocurrencies, fiat currencies are essentially government-sanctioned money. Fiat currency is an important term used to refer to traditional money that we use every day. For example, currencies like the U.S. dollar (USD) or the Euro (EUR) are fiat currencies.
Evolution of money

Perhaps we should briefly explore the evolution of money to help you put the existence of fiat currency in perspective.

Bartering

Bartering is based on a simple concept: Two individuals negotiate to determine the relative value of their goods and services and offer them to one another in an even exchange. It is the oldest form of commerce, dating back to a time before hard currency even existed. For example, when farmers used to sell their crops, they would trade apples for oranges, onions for potatoes, etc.

Commodity currency

In commodities, the society accepts some specific commodity as a medium of exchange and, based on the characteristic of that commodity, defines the functions it can possess in the role of money. But like barter, it had some attributes within itself but lacked in some functions like playing the role of an accounting unit. As the number of goods rises, the calculation for finding the correct amount of one good compares to another one raised in complexity exponentially.

Gold and silver are probably the most famous forms of commodity currency.

Paper money

It was found inconvenient as well as dangerous to carry gold and silver coins from place to place. The invention of paper money marked a critical stage in the development of money. Paper money is regulated and controlled by the Central bank of the country. At present, a considerable part of money consists mainly of currency notes or paper money issued by the central bank.

Credit Money

The emergence of credit money took place almost side by side with that of paper money. People keep a part of their cash as deposits with banks, which they can withdraw at their convenience through cheques. The cheque (known as credit money or bank money) is not money, but it performs the same functions as money.

Plastic Money

The latest type of money is plastic money in the form of Credit cards and Debit cards. They aim at removing the need for carrying cash to make transactions.

Fiat Currency vs. The Gold Standard

To better learn about the idea of a currency being ‘backed’ by something valuable, we’ve already explored its relationship to Gold. In 1971, then U.S. president Richard Nixon put an end to the “Gold standard.” Before that, the value of the U.S. dollar (USD) was linked to the Gold value. Currently, the U.S. treasury securities back the dollar. Treasury Securities are the government’s way of collateralizing debt.

Today, a fiat currency doesn’t have a value of its own. All fiat currencies are backed by nothing but trust and faith we put in its value. To put it simply, fiat currencies are valuable because we believe and unanimously agree on their value.
Qualities of fiat currency:

  • Unlimited supply
  • The scarcity of a physical commodity like Gold does not impact or limit the supply of a fiat currency
  • Affordable to produce
  • Fiat money is more affordable to produce than commodity-based money
  • Widely acceptable
  • Undoubtedly, fiat money is a widely accepted medium of exchange in international trade.

Risk of hyperinflation

Historically, the implementation of fiat currency systems has typically led to financial collapses, which indicates that these systems present some risks.

No Intrinsic Value

Fiat currency holds no intrinsic value. This allows governments to create money from nothing, leading to hyperinflation and the collapse of their economic system.

Fiat Currency vs. Cryptocurrency

Fiat money’s value is inextricably linked to decisions made by central authorities, namely governments and central banks, regarding their monetary and fiscal policy. For fiat currency to be issued, a central bank simply gives the order. Alternatively, cryptocurrency derives intrinsic value from its native blockchain, where monetary policies are transparent and written into the protocol’s codebase.

Another difference between fiat vs. cryptocurrency is how each of these currencies is generated. Bitcoin, like most cryptocurrencies, has a controlled and limited supply. In contrast, banks can create fiat money out of nothing, according to their judgment of a nation’s economic needs.

Additionally, the cryptocurrency market is much smaller and, thus, way more volatile than traditional markets. This is probably one of the reasons cryptocurrencies are not yet universally accepted. The rapid expansion and adoption of digital currency markets indicate a growing acceptance of cryptocurrency on both the individual and the institutional levels.
Closing thoughts

As history has proven, money and the systems that underpin it will continue to evolve. While fiat currency is still the dominant form of money, cryptocurrencies and blockchain technology may very well represent the next step in the evolution of money.