Definition, History, and How It Works

• 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.

Whether someone hands you a $1 bill or a $100 bill, both are just pieces of paper that don’t inherently have any differences in value — or any value at all, for that matter. Or if someone Venmos you $1 vs. $100, it’s just a matter of typing out some extra zeroes.

What really differentiates these transactions and gives our current monetary system value is that people trust the authorities that issue our main currency (the dollar in the U.S.), and there’s an implied confidence that this currency will be accepted in any transaction. That’s the principle behind fiat money, which means legal tender based on a government decree, and in a modern sense, it means any currency that is backed by faith in the government, not an underlying asset like gold.

While fiat money has been the norm in the U.S. 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 U.S. Dollar, Euro, British pound, and Japanese Yen are all examples of fiat money backed by an issuing government. Generally, when you think of a national or regional currency, that’s fiat money nowadays.

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

What is fiat money?

Fiat currency definition

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.

Why is it called fiat money?

The term “fiat” is derived from the Latin word that translates to “let it be done,” which essentially means that it applies to an authoritative determination or order.

History of fiat money

Origins and evolution of fiat money

Fiat money is generally considered to have originated in China several hundreds of years ago, although there are some differing accounts of when exactly paper currency in China started to become untethered to underlying assets.

Other issuances of fiat currency have also cropped up throughout history, even before becoming official policy. For example, during the American Civil War, the U.S. government sold “greenbacks” to help finance the war, but these were not backed by gold, thereby making them a fiat currency. However, the Specie Payment Resumption Act of 1875 reinstated the convertibility of greenbacks into precious metals and got the U.S. back to the gold standard — until President Richard Nixon announced the end of the gold standard in 1971.

The 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 U.S. 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. Paper currencies later emerged, but these still often served as promissory notes to pay specific quantities of gold and silver.

Countries like the U.K. and the U.S. 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 known as the Bretton Woods System, positioning the U.S. dollar as a global reserve currency.

Under this system, many international currencies were tied to the dollar, and the dollar converted to gold at a fixed exchange rate. The gold standard was in place until 1971, when President Nixon, faced with surging inflation and high unemployment, suspended the convertibility of dollars into gold. At that point, the amount of foreign-held dollars exceeded the amount of gold in the U.S. reserves, threatening the stability of the Bretton Woods system, which ultimately ended in 1973. Now, the U.S. relies more on levers such as the Federal Reserve’s interest rate policy and bond-buying activity to help control the money supply and mitigate inflation; still, the value of the dollar ultimately is based on faith in the government and the willingness to accept it as payment, rather than being tied to an underlying asset like gold.

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 U.S., 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 — too much money in circulation can ultimately erode purchasing power to the point where people struggle to afford essentials.

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 Ethereum, there’s been debate about whether such digital assets could ultimately supplant fiat money as the preferred medium of exchange or 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, and head of managed wealth at Onramp, a Bitcoin custody solution.

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. 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 starting to approve some crypto ETFs to be traded on the traditional stock market in 2024.

Some cryptocurrencies, called stablecoins, can be pegged to commodities or fiat money, which is 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, so it’s important to understand exactly what a digital asset stands for before engaging with it.

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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