Fiat currency, also chosen fiat money, is legal tender whose value is backed by the regime that issued it. This differs from money that is backed by some concrete asset that sets the standard of its value, such as golden.

A common misconception is that, dissimilar currencies of the by that were based on a gold, argent, or other precious metal standard, fiat currencies don't have "anything" backing them. A more authentic description is that a fiat currency is backed by the resource of the government that issues information technology, while its value is determined past a number of factors, including economical supply and demand, interest rates, and the money supply.

Two signs pointing in different directions, with fiat currency and crypto currency printed on them.

Image source: Getty Images.

A cursory modern history of currencies

In contempo centuries, currencies were made of a concrete detail with an agreed-upon value, near usually metals such as gold, silver, copper, and bronze. The best case is the British pound sterling, which began equally a silver coin that weighed one Troy pound. The clarification was literal: one pound of sterling silver. The value of these concrete coins was in the money itself.

From there, governments began issuing paper currency, or notes that were redeemable for a measure of the backing standard. For the British pound sterling, the answer was actually gold, beginning in the 1700s. In the U.Southward., a single dollar was redeemable for gilt until 1933.

Over the past century, governments take moved away from the gold standard. Currencies now are almost universally backed by the governments that consequence them. An example of a fiat currency is the dollar. The U.S. government officially ended the relationship between gilt and the dollar in 1976.

The pros of a fiat currency

The biggest reason why countries stopped using a gold standard is that it limits a regime'southward ability to respond to economic events. For example, with a gold standard, the money supply is tied to the available supply of gilded, while a country'southwarddemandfor money changes based on the growth of its population and economic system.

Consider the U.S. as an example. Since the dollar was decoupled from gilded, the population and the economy have grown significantly:

US Population Chart

U.S. population data by YCharts.

If the U.Due south. and other nations had remained on a gold standard, the earth's supply of money would be express to the available golden. And while the amount of gold on earth hasn't increased much over billions of years, the human population, its economic output, and the demand for coin certainly have gone up.

With a fiat currency, the coin supply can exist increased far more hands equally demand increases, helping to stabilize a currency'southward spending power and preventing deflation, or the falling price of appurtenances.

Before you say, "Falling prices are skilful," remember that at that place's a producer on the other side of every purchase. Falling prices tin can be disastrous for producers, particularly if they happen chop-chop. This can effect in large economic shocks, forcing companies to cutting costs, lay off workers, or have other actions to stave off losses in a deflationary environment. And thatcan atomic number 82 to a domino upshot, pain more than businesses as they lose customers or their customers spend less, leading to more cuts and job losses.

And there you lot have an example of the get-go advantage of fiat currency -- existence able to manage the money supply to make sure there's plenty to prevent economy-crashing deflation.

Some other advantage of a fiat currency is that it can be used to back up volatility in an economy, including supporting debt markets. A cardinal bank can have avails on its own residuum sheet, such as the Fed'southward buy of U.Due south. federal debt and mortgages.

Increasing the coin supply may audio like a fundamental bank, such as the U.South. Federal Reserve Board, can merely magically make coin appear out of sparse air. To some degree, that'due south true, merely it's besides an oversimplification. The Fed doesn't so much create coin out of sparse air as exchange newly made coin for an asset, such equally a loan to a bank, a U.S. Treasury bond, or a mortgage-backed security. In other words, when the Fed "makes" new money, it'south because there is existent-world demand for it.

Cons of fiat currency

There are really ii major risks with fiat currency: political instability and mismanagement of the money supply.

Let's talk near political instability. Money, whether fiat or gold-backed, is a shared fiction: Information technology'due south worth something because we all agree it'south worth something. With fiat currency, the foundation is trust that the government that issued it volition remain stable and in power, keeping the currency worth what we all agree on. Without a trustworthy, well-run, and resourceful authorities, religion in a fiat currency tin erode, resulting in steep inflation as it loses spending ability.

Mismanagement of the coin supply -- peculiarly increasing the money supply -- is a risk that many people fearfulness with fiat currencies. This is particularly concerning for many due to massive government stimulus efforts during the COVID-xix pandemic in 2020 and 2021. Using the U.S. as an instance, the money supply increased almost 40% from the beginning of 2020 through December 2021:

US M2 Money Supply Chart

U.S. M2 money supply data by YCharts.

The U.S. economy and population, however, didn't grow past 38% over that two-twelvemonth menstruum. Much of that new money issued was debt the U.S. regime issued to pay for economic stimulus; similar increases happened in other economies around the world.

The take chances is that the massive increase in the money supply could lead to hyperinflation.

Cryptocurrencies and fiat money

Worries about inflation and government command over money and economic policy take led many people to consider cryptocurrencies. As a decentralized digital asset, cryptocurrencies are very appealing to anyone who is suspicious of authorities manipulation of money. They are too becoming increasingly useful equally portable, digital stores of value. And, every bit we have seen over the past several years as many have gained immensely in value, they can hedge your wealth against inflation.

The cryptocurrencies on the strongest, most secure, and most capable blockchain networks could grow more valuable for some other important reason, too -- the innovation in uses happening on the blockchain.

Nosotros could really see fiat money become cryptocurrencies in the future, too. Many governments have begun studying digital currency, and a regime-built and -backed cryptocurrency seems well-nigh inevitable at some indicate. El Salvador adopted Bitcoin (CRYPTO:BTC) as legal tender in 2021.

Today at that place are really cryptocurrencies that are pegged to the value of fiat currencies, called stablecoins. Tether (CRYPTO:USDT), which is "tethered" to the U.S. dollar, is the largest.