When you enter the financial world, you encounter such concepts as money, currency, and fiat money. And you might wonder while hearing these words whether they differ. Are money, currency, and fiat money interchangeable synonyms or are there conceptual differences between these notions? In what follows, we are shedding some light on these concepts, dwelling longer on the concept of fiat money.
How Do Money and Currency Differ?
The two concepts money and currency seem interchangeable, but they are fundamentally different. These are several points at which these two concepts diverge:
- Money is not tangible. They cannot be touched or smelled. Money is seen only as numbers. Currency is, by contrast, tangible. It is the promissory note or coin that can be touched, smelled, cast up or down, or kept in your wallet.
- Money takes the form of numbers. Currency is shaped as coins, banknotes, or hard plastic.
- Money can be transferred online, whereas currency must be transferred physically. You hand currencies out to another person.
What Is Fiat Money?
The concept of fiat money is not difficult to understand. Etymology of the word fiat might be helpful. This word comes from the Latin word facio – facere meaning “to do” and in Latin means “let it be done.” It, therefore, presupposes some authority behind it. When we hear the words fiat money, we hear the authoritative voice giving it permission to exist. And indeed, fiat money is currency backed by the government that issued it. Imagine the government minting fiat money and confirming its existence by its authority and you will understand the concept of fiat money.
How Does Fiat Money Differ from Commodity Money?
Another type of money – commodity money – is backed by precious commodities – gold or silver. The value of fiat money is not derived from the value of gold or silver but from the relationship between supply and demand. Its value also depends on the stability of the government that issued it rather than on the stability and worth of commodities backing it, as is the case with commodity money. Note that the majority of our paper money, be it the US dollar, the euro, or the British pound, are fiat currencies.
It is worth emphasizing that fiat money has value only because the government decides to maintain its value. Two parties in a transaction can agree on its value, too. Fiat money is inconvertible and cannot be redeemed. Because fiat money is not backed by physical reserves, such as gold or silver, it can lose value due to inflation or hyperinflation. If people stop believing in their country’s currency, it will stop having any value. Herein lies the major difference between fiat money and commodity money. Currency backed by gold or silver does have intrinsic value, absent in fiat money, because of the demand for gold in jewelry, decoration, electronic devices, or aerospace vehicles.
The credit theory of money maintains that money should not be backed by commodities or any other valuables. This theory views all money as a credit-debt relation, which in itself is binding. Therefore, to be valuable, money does not need to be backed by anything at all.
Is the US Dollar Fiat Money?
Like the majority of the major currencies, the US dollar is fiat currency. But this was not always the case. Earlier in US history, the greenback was backed by gold and sometimes silver. In 1933, however, the federal government signed the Emergency Banking Act that disallowed citizens to exchange currency for government gold. The gold standard, which backed US currency with federal gold, ended completely in 1971. That year, the government also stopped issuing gold to foreign governments in exchange for US currency.
Since 1971, the US dollars have been backed by the “full faith and credit” of the US government, “legal tender for all debts, public and private” but not “redeemable in lawful money at the United States Treasury or at any Federal Reserve Bank,” according to the words formerly written on the American banknotes. These days, US dollars are “legal tender,” rather than “lawful money,” exchanged for gold or silver.
Advantages of Fiat Money
Fiat money plays the role of a country’s money by storing value, providing a numerical account, and facilitating exchange. Fiat currencies became particularly popular in the twentieth century, because governments and central banks wanted to protect their economies from the worst effects of the natural blossoming and crush of the business cycles. Because fiat money is not as rare as gold, central banks have more control over its supply. Having this control over money gives them the power to manage economic variables – interest rates, liquidity, credit supply, and money velocity. Fiat money gives governments flexibility to manage their currency, set monetary policy, and even stabilize global markets. Commercial banks can also increase the amount of money in circulation, when they need to meet particular demands from borrowers.
What Are the Alternatives to Fiat Money?
Gold and silver coins used to participate in monetary exchanges. These days, you can definitely buy or sell gold or gold coins but you cannot use them in exchange for everyday purchases. Gold and gold coins have turned into speculative assets.
Many people view Bitcoin and other altcoins as a new alternative to fiat money, since they challenge their inflationary nature. And yet, even though the popularity of digital coins has been growing, they have not become money in our traditional understanding of the concept.