In the wake of cryptocurrency, you may need a quick refresher on fiat currency. Fiat currency, also known as fiat money, is defined as, “inconvertible paper money made legal tender by a government decree.” The money itself holds no intrinsic value as opposed to physical commodities such as gold and silver. Therefore, the value of fiat money is dependent upon trust within the market system. The most well-known fiat currencies include the the U.S. dollar and the Euro. However, each country often has their own payment system, thus resulting in varying fiat currencies across the world.
Although trust is necessary for fiat currency to be functional, fiat currency allows for the transfer of value from one individual to another. This is more efficient than barter, which was the common way of exchanging goods and services before the existence of banks.
The value of fiat currency may increase or decrease as supply and demand ultimately determine the value of a particular currency. Since a fiat currency is not backed by anything, it is only worth as much as people perceive it to be. If people believe it is not worth what the government says it is worth, or what it says on the paper it is issued on, then it will in fact become worthless. Both individuals have to agree on the value of the fiat currency for an exchange to occur.
A major concern of fiat money is the ability of governments and central banks to introduce more money into the economy. An excess supply of currency would result in a worthless currency, also known as hyperinflation, as overproduction of money would create a surplus of supply over demand of this currency. Demand for currency is primarily driven by growth in transactions due to economic activity, or growth in gross domestic product (GDP). Another concern is due to fractional reserve banking. The majority of money in the economy today is created by banks through debt. How is this worrisome?
The 2007-2008 global financial crisis is attributed to banks distributing loans that were considered high risk to individuals who did not have the necessary means to pay back these loans. This resulted in individuals defaulting on their loans and the collapse of the entire market, in which the government was forced to bailout large financial institutions.
Before fiat currencies, currencies tied to gold or silver were the most common form of legal tender. Backed by a commodity, these currencies tend to be more stable, as the supply is limited.