We would often hear our grandparents say that when they were kids, they would get a coin of 25 paise to buy ice cream cones for the whole family. Then, our parents said that they got ₹2 coins to buy those cones. Today, we buy those for ₹50.
It is fascinating how price of a single commodity could take so many shapes, literally. 25 paise coins were round and small. ₹2 coins are a bit bigger. And the ₹50, well, they are no circular metal thing but a piece of rectangular paper.
Ever wondered how they came into existence? How they evolved? What are they backed by? How can a piece of paper hold monetary value?
Let’s find that out today.
What is Fiat Currency?
The type of money that has no intrinsic worth but is accepted by the government as legal tender, is called as fiat currency. Historically, currencies were backed by physical commodities such as silver and gold, but today's fiat money is dependent on the trustworthiness of the issuing government.
Fiat money was introduced as a substitute for commodity and representational money, with supply and demand determining its value. Commodity money consists of precious metals such as gold and silver, whereas representational money is a claim on a redeemed commodity. Around 1000 AD, China was the first country to introduce fiat currency and the currency swiftly spread around the world.
After US President Richard Nixon signed legislation removing the dollar's rapid convertibility to gold, it gained appeal in the twentieth century. The majority of countries presently use fiat currencies based on paper that are primarily used for payment.
Unlike traditional commodity-backed currencies, fiat currency cannot be converted or redeemed. It has no intrinsic value and is solely used in accordance with government directives. Counterfeiting of fiat currency must be stopped and money supply must be controlled correctly for it to be successful.
History of Fiat Currency
The Yuan, Tang, Song, and Ming dynasties were the first to use fiat money in the 10th century. Coins made of precious metals were used for the exchange goods. But it soon outstripped the availibility of those metals. People were forced to switch from coins to notes due to shortage of those metals.
In around 1000 AD, the Sichuan region in China saw a boom in business, which again resulted in shortage of metallic coins.
Traders began to issue private notes which were backed by a monetary reserve. This is regarded as the first legal tender.
During wartime, countries use fiat currencies to secure the value of precious metals like gold and silver. Like for example, during the American Civil War, used a fiat currency that was called "Greenbacks". The government stopped printing paper cuurency that could be used to buy gold or silver.
How Does Fiat Money Work?
Rather than being backed by any real element, fiat currency is guaranteed by the trust of its holders and the virtue of a government declaration. Paper money is used to store purchasing power and as a substitute for barter. It allows people to purchase what they require without having to exchange commodities for products, as was the case with barter economy. Because of its ability to store purchasing power, people can readily make plans and construct specialised economic activity. For example, a mobile phone manufacturer can invest in new equipment, hire and pay new employees, and expand into new areas.
The success of a country's economy, governance, and the impact of these factors on interest rates affect the value of fiat money. Political upheaval is likely to result in a weak currency and higher commodity costs, making it difficult for individuals to buy the products they need. It works successfully when the public has sufficient faith in a fiat currency's ability to operate as a storage medium for purchasing power. It must also be backed by the government's complete faith and credit, with a decree issued by the government and printed as legal money for financial transactions.
Advantages and Disadvantages of Fiat Currency
There are several different advantages of fiat money. Some of the benefits of fiat money are as follows: –
Unlike cash, Fiat money has a consistent value based on a commodity such as gold, silver, copper, or other metals. The currencies of commodities, on the other hand, are very volatile due to the regular business cycle and occasional recessions. The country's central bank, on the other hand, can produce or keep paper money as needed, giving them tight control over capital supply, interest rates, and liquidity.
Fiat currency is the most widely accepted kind of currency. Multiple currency exchanges and payment networks all around the world support it. This increases the value of fiat money.
Because governments manage the money supply and fiat currency is not based on unpredictable commodities, it helps to keep a country's economy stable.
Unlike money based on commodities such as gold, silver, or copper, fiat money has a steady value, whereas currencies based on commodities are volatile due to the regular business cycle and recurrent recessions. On the other hand, the country's central bank has the ability to produce or hold paper money as needed, giving it tight control over money supply, interest rates, and liquidity.
Fiat currency is the most widely accepted currency, with many currency exchanges and payment networks supporting it around the world. This increases the value of fiat money.
It aids in the stabilization of the country's economy because the government has control over the supply of money and fiat currency is not based on a volatile commodity.
There are some limitations of the Fiat Money which includes the following:
Although it is usually considered that fiat currency is the more stable currency that can help in the event of a recession, critics argue that gold's limited supply makes it a more stable currency than fiat currency, which has an endless supply.
Another downside of fiat currency is that it has the potential to lose all of its value if the paper on which it is printed loses all of its worth. The economy of the country and everyone who uses the money will be irreparably wrecked if the currency's value begins to fall towards zero.
Because the government has the power to issue fiat currency whenever it wants, it has the ability to steal the resources of the country's citizens even if they refuse to pay taxes. In that instance, the government will slightly inflate the currency and then purchase whatever they require prior to the price increase.
Every year, a fresh batch of money is created to replace banknotes that have been lost or destroyed and are no longer in circulation. However, because of this reason, more currency is issued than is required, causing fiat currencies to lose value over time.
Fiat Currency v/s other types of currency
Fiat Money vs. Crypto currency
Fiat money is a type of legal tender, or a currency that the government has considered legitimate and whose value is guaranteed by the issuer (the government). Crypto currency, on the other hand, is a decentralized digital currency that uses block chain technology to back it up. It is not backed by a government or other central authority.
In comparison to fiat money, a crypto currency is more volatile and provides a higher level of information security. Although some individuals believe that crypto currencies will eventually replace fiat currencies, fiat money is still used in the majority of transactions around the world.
Fiat Money vs. Commodity Money
Commodity money has intrinsic value, which means that it has a real or perceived value. This sort of cash is made from a valuable commodity like gold or silver. Also fiat money has no intrinsic value. Consider dollar bills: they're all made of the same paper, but their value varies based on what a government considers the currency to be worth.
Fiat Currency vs. Representative Money
The government also creates representative money, but unlike fiat money, it is backed by a physical product. There are various types of representational money that signify an intent to pay, such as credit cards and checks.
Although the government backs fiat money, representational money can be backed by a variety of assets. A check and a credit card, for example, are backed by funds in a bank account.
Fiat currency is the most widely accepted currency, with many currency exchanges and payment networks supporting it around the world. To put it another way, fiat money has no intrinsic worth and is determined by market forces. Because governments have control over the supply of money and fiat currency is not dependent on a volatile commodity, this aids in the stabilization of the country's economy. However, the government must exercise extreme caution while producing fiat money, as the value of the currency may fall due to over-circulation, perhaps leading to hyperinflation. As an alternative to representational and commodity money, governments developed fiat money.