What Is Fiat Currency?

Basically, fiat currency is a form of legal tender whose value is determined by the government that issued it and not a physical product or commodity. As a result of this type of money, the strength of the government that establishes the value of the fiat currency is vital. Almost all countries in the world utilize the fiat currency system when purchasing goods and services, investing, and accumulating savings. The value of legal tender is determined by the value of fiat currency, which took the place of gold standard and other commodity-based systems.

The Rise of Fiat Currency

China was the originator of the fiat currency centuries ago. As early as the 11th century, the province of Szechuan began issuing paper money. First of all, it could be exchanged for silk, gold, and silver. The currency system was eventually established by Kublai Khan during the 13th century when he came to power and established a fiat currency system. The historians assert that the use of this money contributed to the fall of the Mongol Empire, with hyperinflation and excessive spending at the root of its demise.

During the 17th century, fiat money was also used in Europe. It was widely adopted by Spain, Sweden, and the Netherlands. In Sweden, the system was eventually abandoned for the silver standard due to its failure. In the next two centuries, New France in Canada, the American Colonies, and finally the United States. governments also experimented with fiat money, but the results were mixed.

By the mid-20th century, the U.S. was back to using commodity currencies. The government ceased the practice of exchanging paper money for gold in 1933. In 1972, the U.S. abandoned the gold standard altogether under President Nixon, marking the end of gold standard on an international scale, and switching to a fiat currency system. Fiat currency has been used across the world since then.

Fiat Currency vs. The Gold Standard

Gold standard allowed paper bills to be converted into gold. As a matter of fact, all paper money was backed by a finite amount of gold, which was kept by the government. According to a system based on commodity-backed currencies, governments and banks were only allowed to introduce new currencies into the economy if they held equivalent amounts in gold stores. A system like this is one that limits the government's ability to create money and to increase the value of their currency entirely based on economic factors.

However, in the case of a fiat currency system, there is no way to convert the money into anything else. By using fiat money, a government can directly influence the value of its currency and link it to economic factors. There is a lot more control of currency systems in the hands of governments and the central banks in these countries. A variety of financial events and crises can be addressed with a variety of tools, such as fractional reserve banking and quantitative easing.

Advocates of the gold standard argue that commodity-based currency systems are more stable because they are backed by something physical and valuable, and therefore more stable. Supporters of fiat currencies counter that gold prices have anything but been stable. Accordingly, the value or worth of both the commodity-based currency and the fiat currency can fluctuate at any time. When a government has fiat currency, it has more flexibility in deciding how to act when there is an economic emergency.

Some Pros and Cons of Using Fiat Currency

Fiat currency isn't unanimously supported by economists and other financial experts. Defenders and opponents passionately argue about this currency system.

The scarcity of a physical commodity like gold has no impact and is not limited by the scarcity of fiat money.
Fiat money is less expensive to produce than commodity-based money.
Fiat currency enables governments and central banks to respond to economic crises with flexibility.
Trade internationally: Fiat currency is widely used around the world and is an acceptable form of currency for international trade.
Unlike gold, fiat money isn't reliant on physical reserves that need to be stored, protected, monitored, and so on.
There is no intrinsic value to fiat money. Creating money from nothing allows governments to cause hyperinflation and collapse their economic system.

Fiat Currency vs. Cryptocurrency

There is a bit of common ground between fiat currency and cryptocurrency in that neither of them is backed by a physical commodity of some sort. But here is where their similarity ends. The majority of fiat money is controlled by governments and central banks, whereas cryptocurrencies are largely decentralized, largely because cryptocurrencies are backed by a distributed digital ledger known as Blockchain.

It is also notable that between these two types of currencies there is another significant difference in how each of these currencies is generated. The supply of Bitcoin, like most cryptocurrencies, is controlled and limited. In contrast, banks can create fiat money from nothing, depending on their judgment of a nation's economic needs.

Bitcoins, as a digital form of money, have no physical counterpart and are borderless, which makes them less restrictive for international transactions. Moreover, cryptocurrency transactions are irreversible, and their nature makes tracking them more difficult than with fiat currency.