Fiat Money

Fiat money is currency that serves as money because a government has declared it to be money and the public accepts it, without any promise that it can be exchanged for a commodity. The Federal Reserve Bank of Dallas puts it simply: "Fiat money is money by decree," and its value "comes exclusively from the willingness of people to accept it as payment." A Federal Reserve Bank of St. Louis lesson defines it as money that "has no intrinsic value (no value of its own) or representational value (does not represent anything of value, such as gold)." It is usually contrasted with commodity money, which is valuable in itself, and representative money, which is a claim on a commodity held elsewhere. "Fiat currency" means the same thing.

What makes the dollar fiat money. Federal law, at 31 U.S.C. 5103, provides that United States coins and currency, "including Federal reserve notes," are "legal tender for all debts, public charges, taxes, and dues." Nothing in that status depends on gold. The Federal Reserve states that its notes "are not redeemable in gold, silver, or any other commodity," that they have not been redeemable in gold since January 30, 1934, and that they have not been redeemable in silver since the 1960s. The dollar's link to gold for foreign governments ended later: on August 15, 1971, the United States closed the gold window, and in the words of Federal Reserve History, "in effect, the international monetary system turned into a fiat one." The gold standard page covers how that system worked and how it ended.

Not backed by gold, but not backed by nothing. A common misunderstanding is that fiat money has nothing behind it at all. The Federal Reserve explains that Congress requires each Reserve Bank to hold collateral equal in value to the notes it puts into circulation, and that this collateral "is chiefly held in the form of U.S. Treasury, federal agency, and government-sponsored enterprise securities." What a note holder cannot do is turn the note in for a fixed quantity of a commodity. The value of a dollar to its holder is what it will buy.

Why it matters to a household. Under a commodity standard, the amount of money is tied to the amount of the commodity. Under a fiat system, it is managed, in the United States by the Federal Reserve. The Dallas Fed describes the trade-off: the money supply "can grow and shrink to meet demand," but "if a regulating body makes too much available, inflation," the general rise of prices, "can occur." For savers and investors the consequence is that cash and fixed payments lose purchasing power over time whenever prices rise, which is why long-term plans are built around real returns after inflation. The extreme version of that risk is hyperinflation, which has struck particular fiat currencies under particular conditions.

Where newer forms of money fit. A stablecoin that tracks the dollar is pegged to fiat money rather than replacing it, and a central bank digital currency would be a digital form of a central bank's money. Cryptocurrencies such as bitcoin are not legal tender in the United States, and the St. Louis Fed lesson uses them as a test case for what counts as money at all.

A fiat system works through law and confidence together. The law makes the currency legal tender, so debts and taxes can be settled in it. Confidence that the next person will accept it, and that it will still buy roughly what it buys today, keeps people using and saving in it. The central bank manages the quantity of money and the level of interest rates to keep that confidence intact.

Consider an example of what managed money means for a saver, with assumed numbers. If prices rise at 3% a year for twenty years, they end up about 1.806 times as high (1.03 raised to the twentieth power). So $100 held as cash will then buy what $100 divided by 1.806, or about $55.37, buys today. The note still reads $100 and is still legal tender; what has shrunk is what it can buy. Money invested at a return above the inflation rate keeps or gains purchasing power instead.

Pros

• The money supply can be adjusted to the economy's needs rather than to the amount of gold or silver that happens to exist.
• No resources are tied up mining or storing a metal to back the currency.
• Prices are not exposed to swings in the market value of a commodity used as money.

Cons

• Its value depends on sound management; issuing too much money produces inflation.
• Holders cannot convert it into a commodity if they lose confidence in it.
• Cash savings lose purchasing power whenever prices rise, so idle money held for long periods tends to shrink in real terms.