Fiat Money

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Definition of Fiat Money:

Fiat money is money whose value is derived from a government decree, or fiat. It is not backed by a commodity and the value of the material it is made of is insignificant. 

Detailed Explanation:

The value of the paper that a $5 bill is written on is less than $5. The currency, or Federal Reserve Note, is not redeemable in gold, silver, or any other asset. (This does not mean that it cannot be used to purchase any of these commodities at the market price.) Its value is derived from its acceptance. The bill is accepted because the government declares that it is accepted as legal tender.

The value of fiat money is determined by supply and demand, which are influenced by the stability of an economy and the management of the money supply by the central bank. Hyperinflation is caused by the printing of money. This combined with a public’s reluctance to accept the currency results in a currency that is worthless. When the public no longer accepts the value of fiat money it will turn to commodities such as gold or silver to trade. Unlike representative money, which has an asset backing the currency, fiat does not have the protection of the underlying value of an asset. Fiat money has an advantage over representative money in that it is not tied to the supply of an underlying commodity. Monetary policy could not be stifled if the government owns less than a sufficient supply of the commodity to increase the money supply.

Fiat money became common in 1971 following the collapse of the Bretton Woods system, and President Nixon declared the United States refused to allow the conversion of dollars into gold.

chart showing fiat money

Dig Deeper With These Free Lessons:

What is Money
Fractional Reserve Banking and The Creation of Money
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