Personal Finance

Fiat Currency Definition and Your Guide to the Money System

fiat currency definition

Do you know what the money in your pocket is called? Yes, we call it, “money,” but that is not its official terminology. The money that you, I, and everyone else use is, “fiat currency.” Fiat currencies comprise the global Fiat system, which treats money as a medium of financial value, for purchasing power and transactions. But that’s just a very basic fiat currency definition.

There’s a lot more when it comes to how our money works. Do you know where the value in money comes from? Basically, it comes from your faith in the government and government legislative authority. Paper money and metal coins, all fiat currencies, are inherently worthless. The monies themselves have no value at all. Fiat currencies gain their value by a government’s legal mandate decreeing their value.

Fiat Currency Definition and Determining Value

Only a government can declare fiat currencies legal tender, which allows us to use it for legal financial transactions and debt payments. The faith of the government in the money is how it gains its value. Also, the public at large must have faith in the government that legalizes and prints the money.

If the government loses power and/or the population loses faith that the money in their pockets holds value, the money would have no value. Fiat currencies were originally backed by the value of gold. These were commodity-backed currencies. At one time, you could exchange dollars and gold for one another. However, what was known as the, “Gold Standard,” became obsolete during the Nixon Administration in 1971.

That’s right. These days, there isn’t any commodity, like gold or silver, backing the money in your pocket to ensure its value. The money in your pocket has value because the United States government, as all other governments with fiat currencies, legally declare that it does. That’s it. Without laws declaring fiat currencies as legal tender, the money in your pocket would be worthless. However, it wasn’t always like this.

The Bartering System

What we know as, “money,” went through a three-stage evolution in human history – in the most basic sense. At first, money was an object given value in an agreement between two parties. Or, the bartering system. Precious metals, jewels, seeds, exotic spices, crops, livestock, furs, and anything valuable was a form of proto-money for exchanging goods.

However, this system was lacking in planning for the future. The value and purchasing power of goods in a bartering system didn’t have value for long. If you were a farmer, you could trade for goods and equipment for expansion plans based on the bartering system of today. That may not be enough for ambitious expansion plans for another season.

Commodities Backed Currencies

Paper money and coins have been in use for thousands of years after the obsolescence of the bartering system. The paper money and coin system that we use today probably came into being in the 17th or 18th century. In 1944, at a landmark United Nations conference in Bretton Woods, New Hampshire, commodities like gold backed fiat currencies. Until 1971, gold was behind every American dollar. In 1971, President Nixon ended the so-called gold standard.

Pitfalls of Fiat Currency

The main detriment to the fiat currency system in the threat of inflation. This is when the purchasing power of money shrinks and buys a lot less than in the past. Governments and finance experts always watch for this. The main point to understand is that as long as the government, and you, believe in the value of money, it has value.

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