When people look into their wallets or bank accounts, they often take the complexities of legal tender for granted. Money falls into a variety of categories that affect its overall value. Understanding these categories can be helpful when you invest, exchange, or transfer money. This guide defines “fiat” currencies, which are the most common kind of currency in the world.
The Basics of Fiat Currencies
At one point in time, the U.S. dollar had the backing of precious metals to guarantee its value. Citizens could walk into banks and exchange paper money for physical assets such as gold and silver. The United States and many other countries around the world have since moved to fiat money as their currency.
Instead of having value based on physical commodities, fiat currencies maintain their purchase power through an agreement on their value. Governments preserve this through their own stability, and they can even control money’s worth through supply and demand.
The U.S. dollar is one of the most valuable forms of fiat money, but there are many others out there. This is a short list of some of the highest-valued forms of this currency:
- New Zealand dollar.
- Libyan dinar.
- British pound.
- Swiss franc.
- Australian dollar.
- Gibraltar pound.
- Canadian dollar.
This list isn’t short due to the number of fiat currencies available. In fact, all major monetary systems are fiat-based. This means an exhaustive list would include most of the globe. While basing economies on such systems can lead to potential problems, such as hyperinflation, fiat money carries a variety of benefits as well.
Before understanding these benefits, it’s important to recognize how this form of currency differs from others. This will provide a better understanding of why countries have moved away from systems like the gold standard.
Fiat Money vs. Other Currencies
It’s easy to think that the only difference from fiat currencies and other money types is the backing of commodities. While this explanation offers a simplistic understanding, it’s not an “either-or” situation. Monetary systems with physical asset backing can fall into multiple categories.
In fact, some currency types backed by commodities can have more similarities with fiat money than with other commodity-backed money. The two major currency types that will help you understand this are representative and commodity currencies.
This form of money represents items that hold intrinsic value. Gold or silver certificates, for instance, fall into this category. Before President Richard Nixon separated American currency from gold in 1971, U.S. citizens could exchange paper money for physical assets at banks.
Here are a few forms of representative monies:
- Silver certificates.
- Gold certificates.
- Token coins.
- Land titles.
- Bank checks.
Representative currencies are similar to fiat money because the dollars or coinage themselves have very little intrinsic value. Rather than being backed by a government promise, though, they’re backed by actual assets.
Currencies that carry their own intrinsic value are commodity money. These do not represent something valuable or even a promise of value from a government. Gold, silver, and other precious metals fall into this category.
The first fiat currencies date back to 11th century China, which now uses the yuan. However, commodities far predate this use. In fact, only bartering as an economic system is older than commodity money. Even gold and silver coins are relatively new inventions compared to certain commodities.
Here’s a short list to give you an idea of commodity money types throughout history:
- Cocoa beans.
Each of these items have their own value, so they don’t need promises or physical backing. This differs significantly from fiat currencies. And while this system may seem beneficial over what we currently use, there are many more advantages to a fiat system.
Advantages of Fiat Money
Currencies that do not hold their own intrinsic value—or have no commodity backing—have become the norm in the modern world. Even as opponents of the system point out drawbacks, such as Zimbabwe’s recent hyperinflation or the U.S. housing crisis in the 2000s—it’s difficult to deny the overall benefits.
Zimbabwe and the housing crisis are examples of worst-case scenarios. Fortunately, the benefits of the fiat currency system outweigh these risks. It all comes down to governments maintaining stability and avoiding drastic actions. When done correctly, you’ll see many of the following advantages:
- Avoids problems of scarcity through control of the money supply.
- Allows economic recovery through variables such as interest rates and liquidity.
- Insulates economies from potential disaster caused by natural fluctuations in the business sector.
- Can print or hold paper money in order to counteract normal economic issues.
What about Cryptocurrency?
While commodity and representative money may seem more stable, the fact is that fiat currencies provide benefits for both citizens and nations. Even new types of capital such as Bitcoin and other cryptocurrencies cannot yet match the advantages of fiat systems.
What’s the main difference between fiat and cryptocurrencies? Fiat money derives its value because it’s backed by a government. Cryptocurrency is digital alone, and derives value from its native blockchain. The two systems that govern its distribution and regulation are quite different. Experts generally agree that fiat currencies won’t be entirely replaced by crypto and blockchain. However, their popularity is rising, and their long-term effect on the world monetary system remains to be seen.
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