Fiat currencies are forms of money established by governments as a medium of exchange. They do not have an intrinsic value and have no inherent value in themselves. Governments maintain their value, or parties collaborating in exchange establish their value. The most significant percentage of currencies in the world are fiat currencies.
Fiat currency can be:
- Any money deemed legal currency by a government.
- Any money spent as a result of a government decree.
- State-issued money that’s not convertible to anything else
- A non-valuable object used as a medium of exchange (also known as fiduciary money).
Why Is Fiat Money Valuable?
Compared to commodity-based money such as gold coins or paper bills exchanged for precious metals, the government that created fiat money backs it. It has merit because governments need you to pay taxes in the fiat money they issue.
People will accept it in exchange for paying taxes if they don’t want to face harsh penalties. Other money theories, such as the credit theory, contend that because all money is a credit-debit relationship, it makes no difference whether money is supported by anything to preserve value.
Advantages and Disadvantages of Fiat Money
- Central banks have far more influence over fiat supply, allowing them to manage economic variables such as credit availability, liquidity, interest rates, and money velocity.
- It serves as a sound currency if it can perform the functions of a monetary unit that a nation’s economy requires—storing value, providing a numerical account, and enabling commerce.
- It has excellent seigniorage, which means it is more cost-effective to generate than a currency directly linked to a commodity.
- Risk of inflation.
What Are Some Alternatives to Fiat Money?
Today, virtually every country has legal tender in the form of fiat money. While gold and gold coins can be bought and sold, they are rarely utilized in exchange or for ordinary transactions and are more of a collectible or speculative asset.
Cryptos, like Bitcoin, have developed in the last decade as an alternative to the inflationary nature of fiat currencies. Nevertheless, despite rising interest and adoption, these virtual assets do not appear to be “money” in the classic sense.