Fiat money, also called fiat currency is a form of currency that is recognised as legal tender by the government but has no inherent value. It gains value only because people trust it due to the government order or law. Governments establish trust by declaring it legal tender, allowing all people and businesses to accept it as payment. The majority of modern economies are based on a fiat money system. Coins and bills are examples of fiat money. “Fiat Money” is one of the important concepts in the UPSC/IAS 2023 Economy syllabus which is discussed in this article in detail.

What exactly is Fiat Money?

• Fiat money is a currency issued by the government that is not backed by a commodity such as gold.
• Since fiat money gives central banks control over how much money is to be printed, they have greater control over the economy.
• Governments then outlaw all other forms of money, further cementing trust.
• The value of fiat money is determined by the relationship between supply and demand, as well as the stability of the issuing government, rather than by the value of the commodity backing it.
• When fiat money is backed by a gold or silver standard, it is referred to as "representative money".
• And when the central bank promises "to pay the bearer the sum of this many rupees," fiat currency is referred to as an"anonymous bearer bond with zero interest."
• The majority of modern paper currencies, including the US dollar, the euro, and other major global currencies, are fiat currencies.

Fiat Money – Historical Background

• The term "fiat" is a Latin word that means "it shall be" or "let it be done."
• The origins of fiat money can be traced back to the 11th century Chinese Tang dynasty.
• By the 12th century, fiat money had spread throughout the country. It was known by several names, including jiaozi, huizi, and guanzi.
• In his book The Travels of Marco Polo, Marco Polo described the Yuan Dynasty's fiat money in the 13th century:
• "All these pieces of paper are issued with as much solemnity and authority as if they were of pure gold or silver; and on every piece, a variety of officials, whose duty it is, have to write their names and put their seals."

Features of Fiat Money

The features of fiat money are:

• Fiat money is any currency that is not secured by a commodity.
• Money that has been declared legal tender by a person, organisation, or government is required to be accepted in certain situations as payment for a debt.
• Fiat money is state-issued money that is neither fixed in value according to any external benchmarks nor convertible into anything else through a central bank.
• Money is used as a result of a government order.
• It is a non-valuable item that is used as a means of exchange (also known as fiduciary money).

Why Do Modern Economies Favor Fiat Money?

• Prior to the 20th century, the majority of countries used some form of the gold standard or commodity backing.
• The limited supply of gold coming out of mines and in central bank vaults, however, was insufficient to keep up with the new value being created.
• Global markets and commerce have been severely disrupted as a result.
• Fiat money allows governments more freedom to control their own currencies, establish monetary policy, and maintain market stability.
• Additionally, it permits fractional reserve banking, which enables commercial banks to increase the amount of cash on hand to satisfy borrower demand.
• This is the reason why modern economies favour fiat money.

Fiat Money – Significance

• Fiat money has the potential to be more stable than commodities as a form of money.
• This is due to a consistent supply provided by the central bank or government – whoever is in charge.
• Since fiat money is not a scarce or fixed resource like gold, central banks have far greater control over its supply, allowing them to manage economic variables like credit supply, liquidity, interest rates, and money velocity.
• Fiat money is a good currency if it can perform the functions that a country's economy requires of its monetary unit, such as storing value, providing a numerical account, and facilitating exchange.
• It is less expensive to produce than a currency that is directly linked to a commodity.
• Fiat money gives governments more leeway in managing their own currency, setting monetary policy, and stabilizing global markets.
• It also permits fractional reserve banking, which allows commercial banks to multiply the amount of money on hand to meet borrowers' demands.

Fiat Money – Limitations

• Monetary policies that reduce the value of money result in overprinting of currency, which may result in hyperinflation.
• Itis still bulky to carry, reducing its movability.
• Theft risk and vulnerability to counterfeit (duplicate/fake currency)
• Money cannot be easily divided into small increments to more precisely match commodity values, which leads to the rounding-off problem.
• For example, due to a change problem, petrol pumps are not returning 60 paise per customer.
• Hyperinflation occurs when inflation rises at an extremely rapid rate. Inflation rates can rise from 50 to 300 times.
• If people lose faith in a country's currency, the money loses its value. This is not the same as a gold-backed currency.
• The 2007 mortgage crisis and subsequent financial meltdown, on the other hand, tempered the belief that central banks could always prevent depressions or severe recessions by regulating the money supply.
• Due toits unlimited supply, fiat money provides more opportunities for the creation of bubbles.

Conclusion

Fiat currencies have value only because the government maintains it; there is no utility to fiat money in and of itself. Since there is no underlying commodity backing fiat money, it is inconvertible and cannot be redeemed.