Fiat Money Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Fiat money is a form of money that has no intrinsic value. Its value as money is based on faith in the government that issues it. This faith comes from the general understanding that the government will not create too much money nor too little. Fiat money is not backed by any commodity and therefore has no value in use other than its use as money. The name comes from the Latin word fiat, meaning “by decree.” Fiat money has value as “legal tender” simply because the government decrees it does. Most countries today have fiat-based monetary systems.

Fiat-based monetary systems traditionally begin as commodity-based monetary systems. Commodity money has both monetary and nonmonetary uses (e.g., gold, silver, beads, shells, tobacco, etc.). Commodity money serves well as money as long as the commodity is more valuable as money than it is in its nonmonetary use. In an effort to protect or store these commodities, “representative money” (e.g., coins and paper) is issued that can be traded and easily converted into this commodity. When demand and supply conditions of the commodity or of the representative money change so that it is no longer easily converted, the representative money is either devalued or it transitions to fiat money.

In order for an object with no intrinsic value to become acceptable for use as money, certain network effects must be overcome. In other words, why do people trust it as money? An individual will only accept fiat money if he or she knows that others will accept it as money as well. This acceptance can come through government decree right away, or it can arise gradually through a system of representative money and/or fractional reserve banking.

Monetary systems based on fiat money have often historically come into existence during times of war. This happens when the expense of war exceeds the available government stock of the commodity being used as money or backing representative money. Representative money fails and governments issue fiat money to pay the expenses or debt of war. Often in these instances, governments issue too much fiat money leading to periods of high inflation. During these periods, fiat money loses its ability to serve as a store of value. Examples go back in history, such as the siege of Faenza in 1241, the cases of Germany during the Thirty Years War (beginning in 1618) and later World War I, and, even more recently, in Iraq following the 1991 Gulf War. In extreme cases, the paper it is printed on becomes more valuable as a source of fuel for generating heat than as money.

Fiat money can also evolve as part of a fractional reserve banking system. Fractional reserve banking came into existence when banks (or goldsmiths) would accept deposits in gold and issue paper notes in exchange. Patrons could redeem these notes for gold at any time. Rather than conduct transactions in gold, they began conducting transactions in notes which were lighter in weight and readily accepted. Because people would occasionally exchange notes for gold, bankers would keep a fraction of the gold in the vaults to meet daily withdrawals. They would loan out the rest, thereby creating money through issuing more notes than they kept in gold to back it up. This system works as long as not everyone wants their gold at once. Modern fiat systems today work in much this same manner except that notes are no longer convertible to gold and are instead backed by trust in the government that they will always have value. To maintain this trust, governments must exercise restraint in their willingness to create and destroy money.

Much of the Western world today converted to fiat monetary systems when the United States officially severed all ties of its currency to gold with the abolishment of the Bretton Woods system in 1971. Major Western countries had tied the value of their currencies to the U.S. dollar, which was convertible to gold. When there were many more reserves held in dollars than the United States could possibly redeem in gold, it was eventually forced to abandon the gold exchange system, effectively creating a worldwide fiat system.

Bibliography:

Luis Araujo and Braz Camargo, “Information, Learning, and the Stability of Fiat Money,” Journal of Monetary Economics (v.53/7, 2006);
Peter Howitt, “Beyond Search: Fiat Money in Organized Exchange,” International Economic Review (v.46/2, 2005);
Jumpei Tanaka, “Is Higher Confidence of Fiat Money Necessarily Desirable?,” Economics Letters (v.95/2, 2007);
Varian, “Economic Scene; Paper Currency Can Have Value Without Government Backing, but Such Backing Adds Substantially to Its Value,” New York Times (2004);
R. Vlede, “Lessons from the History of Money,” Economic Perspectives (1998).

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