Fiat Money

Definition

Fiat money is a type of currency that is not backed by a physical commodity, such as gold or silver, but is instead declared legal tender by the government. Its value is derived from the government's declaration that it is a valid form of payment within the economy, rather than from the intrinsic value of the money itself.

5 Must Know Facts For Your Next Test

1. Fiat money is the dominant form of money used in the modern global economy, replacing commodity-backed currencies like the gold standard.
2. The value of fiat money is maintained through government regulation, trust in the issuing authority, and the money's status as legal tender.
3. Fiat money allows central banks to implement monetary policies, such as adjusting interest rates and controlling the money supply, to influence economic conditions.
4. The transition from commodity money to fiat money has given governments and central banks more control over the money supply and the ability to manage economic fluctuations.
5. Fiat money is vulnerable to inflation, as central banks can potentially create too much of it, leading to a decline in its purchasing power.

Review Questions

• Explain how fiat money differs from commodity money and how this difference affects the role of central banks in managing the money supply.
  • Fiat money, unlike commodity money, is not backed by a physical asset like gold or silver, but rather derives its value from the government's declaration that it is a valid form of payment. This distinction allows central banks to have more control over the money supply, as they can adjust the amount of fiat money in circulation through monetary policy tools such as adjusting interest rates and reserve requirements. With commodity money, the money supply was more constrained by the availability of the underlying commodity. The shift to fiat money has given central banks the ability to actively manage economic conditions by manipulating the money supply, which is a key function of modern central banking.
• Describe how the concept of fiat money is related to the measurement of the money supply, as discussed in the topics 27.1 Defining Money by Its Functions and 27.2 Measuring Money: Currency, M1, and M2.
  • Fiat money is a crucial component in the definition and measurement of the money supply, as discussed in the topics 27.1 and 27.2. In 27.1, the functions of money, including serving as a medium of exchange, a unit of account, and a store of value, are all facilitated by the use of fiat money. In 27.2, the various measures of the money supply, such as currency, M1, and M2, all include fiat money as a key element. The fact that fiat money is not backed by a physical commodity, but rather derives its value from government declaration and public trust, allows central banks to actively manage the money supply through monetary policy, which is a central topic in 28.1 on the Federal Reserve Banking System and Central Banks.
• Analyze how the transition from commodity money to fiat money has influenced the role and policies of central banks, such as the Federal Reserve, in maintaining economic stability and promoting economic growth.
  • The shift from commodity money to fiat money has significantly expanded the role and policy tools available to central banks, such as the Federal Reserve, in managing the economy. With fiat money, central banks can more actively control the money supply and interest rates through various monetary policy instruments, such as open market operations, reserve requirements, and adjusting the federal funds rate. This allows them to influence economic conditions, promote price stability, and foster economic growth in ways that were not possible with a commodity-backed currency system. The Federal Reserve, for example, can now use its monetary policy tools to respond to economic fluctuations, stimulate the economy during recessions, and maintain low and stable inflation rates – all of which are critical for maintaining overall economic stability and promoting long-term economic prosperity. This increased policy flexibility afforded by fiat money has been a key factor in the evolution of modern central banking and its role in macroeconomic management.

Related terms

Commodity Money: Commodity money is a form of money that has intrinsic value, such as gold or silver, and is used as a medium of exchange.

Fractional-Reserve Banking: Fractional-reserve banking is a banking system in which banks hold only a fraction of their customers' deposits as reserves, and use the rest for lending or investment purposes.

Monetary Policy: Monetary policy is the process by which the monetary authority, such as a central bank, manages the money supply and interest rates to achieve economic goals like price stability, full employment, and economic growth.