Fiat Money: Definition, History, and How it Works (2024)

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• Fiat money is currency backed by the government that issued it and isn't tied to a commodity such as gold.
• Fiat money issuers can have a lot of influence on the economy by controlling the supply of this currency.
• Overly aggressive monetary policies run the risk of eroding the value of fiat currencies.

You've probably heard the expression, "Backed by the full faith and credit of the US government," in reference to the dollar. That's the principle behind fiat money. Its value is based on people's trust in the authorities that issue it.

While fiat money has been the norm since the early 1970s, the emergence of cryptocurrencies like bitcoin has been gaining acceptance in government and business. Many of the best online brokerages now offer crypto trading in addition to traditional stocks and ETFs.

The US Dollar, Euro, British pound, and Yen are all examples of fiat money backed by an issuing government. Most contemporary fiat money is paper currency.

Here's everything you need to know about fiat money, how it came to be, and its future.

What is fiat money?

Fiat money is a government-issued legal tender. Unlike currencies tied to the value of physical commodities like precious metals, fiat money doesn't have inherent value like gold or silver. Instead, it derives value from the public's trust in its issuers.

The term "fiat" is derived from the Latin word meaning an authoritative determination or order.

History of fiat money

Origins and evolution of fiat money

Fiat money originated in China during the 10th century, primarily during the Yuan, Tang, Song, and Ming dynasties. Due to a limited supply of precious metals (particularly copper during the Song Dynasty), China suffered from a coin shortage. Paper drafts and private notes covered by a monetary reserve became readily accepted soon after and became the only legal tender by the Yuan Dynasty.

France, the Continental Congress, and the American colonies began using paper currency in the 18th century. Government-issued notes were regarded as bills of credit commonly used to pay taxes. Fiat money rose in popularity during times of war to preserve the value of precious metals.

For example, during the American Civil War, people used pieces of paper called "Greenbacks."

Transition from commodity money to fiat money

Most of the world's currency is now fiat money. It began to see widespread use in the 20th century when the US dollar was decoupled from the price of gold.

Commodity money — valued from the underlying price of gold, silver, and other materials — has been used throughout history. Coins made from precious metals were the standard for thousands of years. By the 18th and 19th centuries, paper currencies began to take hold, although many served as promissory notes to pay specific quantities of gold and silver.

Countries like the UK and the US embraced the gold standard, a monetary system tying the value of a standard unit of currency's value to a certain amount of gold. When the Great Depression and two world wars severely affected the global economy, world leaders created an international monetary system, positioning the US dollar as a global currency.

International balances were settled in dollars and converted to gold at a fixed exchange rate. The gold standard was in place until 1971, when US President Richard Nixon, faced with surging inflation and high unemployment, ended it as the amount of foreign-held dollars exceeded the amount of gold in the US reserves.

How fiat money works

Government issuance and regulation

Since fiat money doesn't have intrinsic value and isn't linked to physical commodities, its value derives from people's confidence and trust in the government that issues it. Financial and Federal Reserve authorities strictly regulate and oversee it to maintain and encourage a stable, reliable money system that protects consumers and businesses alike.

The lack of tangible backing allows governments more flexibility in managing and regulating currency. In the US, the Federal Reserve controls the supply of dollars, and the European Central Bank controls the supply of the euro common currency.

Role of central banks

The government's flexibility in regulating its own currency also allows central banks to greatly influence the economy because they can control the money supply. Monetary policies and economic conditions — including interest rates, reserve ratios for banks, and supply and demand — largely determine the value of fiat currency.

However, fiat money is also vulnerable to political instability. This may lead to a weakening currency and diminished value. Another concern is hyperinflation through overprinting, which could lead to an economic disaster.

Pros and cons of fiat money

Future of fiat money

Fiat money has been a reliable global financial system for decades, trusted to facilitate day-to-day transactions, purchases, and trades. But, the emergence of digital money and decentralized assets is quickly reshaping money. A gradual decline of fiat money may be on the horizon.

With the advent of cryptocurrencies such as bitcoin and ether, there's been debate about whether such digital assets could ultimately supplant fiat money as the preferred medium of exchangeor at least provide an alternative.

"Like with any incumbent technology for an existing system, it kind of mostly works most of the time," says Andy Edstrom, CFA and financial advisor at WESCAP Group.

But, as inflation rises and more fiat units are printed, "the cracks are starting to appear in the system," says Edstrom.

Some people fear that the financial authorities cannot employ effective strategies to manage inflation and prevent hyperinflation.There are also concerns about the impact of national debt levels on fiat currency. Long-term, unsustainable debt can diminish people's confidence and lead to further economic instability.

Digital currencies and fiat money

The advent of cryptocurrencies has spurred a debate about the future of fiat currencies and whether they'll ultimately give way to digital coins. Cryptocurrencies such as Bitcoin aren't fiat money because they aren't issued, controlled, or backed by any central authority. In some cases, the total maximum supply is designed to be capped at a certain amount.

The price volatility of cryptocurrencies is one reason some skeptics say they are unlikely to supplant fiat money as the dominant medium of exchange. However, acceptance of crypto has been growing, with the SEC approving two spot crypto ETFs to be traded on the traditional stock market in 2024.

Some cryptocurrencies, called stablecoins, can be pegged to commodities or fiat money, intended to make them less volatile. Some cryptocurrencies have utility, such as transferring payments or powering decentralized networks and applications. Others are created for fun, and some can be scams.

Edstrom explains that cryptocurrencies can be used transactionally but haven't been fully adapted as money due to their volatile nature. "But if Bitcoin reaches its potential over the next decade or two," he says, "then it's likely that the volatility will reduce, and it's likely that Bitcoin will become used commonly as money in the economy as it matures."

Time will tell how cryptocurrencies will ultimately be used for financial transactions and where they'll eventually fit in the international monetary system. For now, keep an eye on the developments and consider the pros and cons of fiat money when making decisions about saving and investing.

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