Fiat money

Fiat money

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Fiat money is money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...

 that has value only because of government regulation or law. The term derives from the Latin
Latin
Latin is an Italic language originally spoken in Latium and Ancient Rome. It, along with most European languages, is a descendant of the ancient Proto-Indo-European language. Although it is considered a dead language, a number of scholars and members of the Christian clergy speak it fluently, and...

 fiat, meaning "let it be done", as such money is established by government decree. Where fiat money is used as currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...

, the term fiat currency is used.

Fiat money originated in 11th century China
China
Chinese civilization may refer to:* China for more general discussion of the country.* Chinese culture* Greater China, the transnational community of ethnic Chinese.* History of China* Sinosphere, the area historically affected by Chinese culture...

, and its use became widespread during the Yuan and Ming dynasties. The Nixon Shock
Nixon Shock
The Nixon Shock was a series of economic measures taken by U.S. President Richard Nixon in 1971 including unilaterally cancelling the direct convertibility of the United States dollar to gold that essentially ended the existing Bretton Woods system of international financial exchange.-Background:By...

 of 1971 ended the direct convertibility of the United States dollar
United States dollar
The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....

 to gold. Since then all reserve currencies
Reserve currency
A reserve currency, or anchor currency, is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves...

 have been fiat currencies, including the dollar and the euro
Euro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...

.

Characteristics


The term fiat money has been defined variously as:
  • any money declared by a government to be legal tender
    Legal tender
    Legal tender is a medium of payment allowed by law or recognized by a legal system to be valid for meeting a financial obligation. Paper currency is a common form of legal tender in many countries....

    .
  • state-issued money which is neither convertible by law to any other thing, nor fixed in value in terms of any objective standard.
  • money without intrinsic value
    Intrinsic theory of value
    An intrinsic theory of value is any theory of value in economics which holds that the value of an object, good or service, is intrinsic or contained in the item itself...

    .


While specie-backed representative money
Representative money
The term representative money has been used variously to mean:*a claim on a commodity, for example gold certificates or silver certificates. In this sense it may be called 'commodity-backed money'....

 entails the legal requirement that the bank of issue redeem it in fixed weights of specie, fiat money's value is unrelated to the value of any physical quantity. Even a coin containing valuable metal may be considered fiat currency if its face value
Face value
The Face value is the value of a coin, stamp or paper money, as printed on the coin, stamp or bill itself by the minting authority. While the face value usually refers to the true value of the coin, stamp or bill in question it can sometimes be largely symbolic, as is often the case with bullion...

 is higher than its market value as metal.

A feature of all fiat money is its acceptability to the government for payment of taxes and charges.

Fiat money is not essential for large countries, nor is it always used. An economy may function on banknote
Banknote
A banknote is a kind of negotiable instrument, a promissory note made by a bank payable to the bearer on demand, used as money, and in many jurisdictions is legal tender. In addition to coins, banknotes make up the cash or bearer forms of all modern fiat money...

s issued by commercial banks, which are not legal tender, and hence not fiat money. This was the situation in the United States during periods prior to 1862, before the first United States Note
United States Note
A United States Note, also known as a Legal Tender Note, is a type of paper money that was issued from 1862 to 1971 in the U.S. Having been current for over 100 years, they were issued for longer than any other form of U.S. paper money. They were known popularly as "greenbacks" in their heyday, a...

s were created and declared by the government to be legal tender.

Early history


The Song Dynasty
Song Dynasty
The Song Dynasty was a ruling dynasty in China between 960 and 1279; it succeeded the Five Dynasties and Ten Kingdoms Period, and was followed by the Yuan Dynasty. It was the first government in world history to issue banknotes or paper money, and the first Chinese government to establish a...

 in China
China
Chinese civilization may refer to:* China for more general discussion of the country.* Chinese culture* Greater China, the transnational community of ethnic Chinese.* History of China* Sinosphere, the area historically affected by Chinese culture...

 was the first to issue paper money, jiaozi
Jiaozi (currency)
Jiaozi is a form of banknote which appeared around 10th century in the Sichuan capital of Chengdu, China. Most numismatists generally regard it as the first paper money in history, a development of the Chinese Song Dynasty ....

, around the 10th century AD. Although the notes were valued at a certain exchange rate for gold, silver, or silk, conversion was never allowed in practice. The notes were initially to be redeemed after three years' service, to be replaced by new notes for a 3% service charge, but, as more of them were printed without notes being retired, inflation became evident. The government made several attempts to support the paper by demanding taxes partly in currency and making other laws, but the damage had been done, and the notes fell out of favor.

The successive Yuan Dynasty
Yuan Dynasty
The Yuan Dynasty , or Great Yuan Empire was a ruling dynasty founded by the Mongol leader Kublai Khan, who ruled most of present-day China, all of modern Mongolia and its surrounding areas, lasting officially from 1271 to 1368. It is considered both as a division of the Mongol Empire and as an...

 was the first dynasty in China to use paper currency as the predominant circulating medium. The founder of the Yuan Dynasty, Kublai Khan
Kublai Khan
Kublai Khan , born Kublai and also known by the temple name Shizu , was the fifth Great Khan of the Mongol Empire from 1260 to 1294 and the founder of the Yuan Dynasty in China...

, issued paper money known as Chao
Chao (currency)
The Chao , was the official banknote of the Yuan Dynasty in China. Unlike the earlier paper money such as Jiaozi, it was the first paper currency to be used as the predominant circulating medium in the history of China....

 in his reign. The original notes during the Yuan Dynasty were restricted in area and duration as in the Song Dynasty. However, in the later course of the dynasty, facing massive shortages of specie to fund their ruling in China, the Yuan Dynasty began printing paper money without restrictions on duration. This eventually caused hyperinflation
Hyperinflation
In economics, hyperinflation is inflation that is very high or out of control. While the real values of the specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases...

. By 1455, in an effort to rein in economic expansion and end hyperinflation, the new Ming Dynasty
Ming Dynasty
The Ming Dynasty, also Empire of the Great Ming, was the ruling dynasty of China from 1368 to 1644, following the collapse of the Mongol-led Yuan Dynasty. The Ming, "one of the greatest eras of orderly government and social stability in human history", was the last dynasty in China ruled by ethnic...

 ended the use of paper money.

18th and 19th century


An early form of fiat currency were "bills of credit." Provincial governments produced notes which were fiat currency, with the promise to allow holders to pay taxes in those notes. The notes were issued to pay current obligations and could be called by levying taxes at a later time. Since the notes were denominated in the local unit of account, they were circulated from man to man in non-tax transactions. These types of notes were issued in the British colonies in America
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...

, particularly in Pennsylvania
Pennsylvania
The Commonwealth of Pennsylvania is a U.S. state that is located in the Northeastern and Mid-Atlantic regions of the United States. The state borders Delaware and Maryland to the south, West Virginia to the southwest, Ohio to the west, New York and Ontario, Canada, to the north, and New Jersey to...

, Virginia
Virginia
The Commonwealth of Virginia , is a U.S. state on the Atlantic Coast of the Southern United States. Virginia is nicknamed the "Old Dominion" and sometimes the "Mother of Presidents" after the eight U.S. presidents born there...

 and Massachusetts
Massachusetts
The Commonwealth of Massachusetts is a state in the New England region of the northeastern United States of America. It is bordered by Rhode Island and Connecticut to the south, New York to the west, and Vermont and New Hampshire to the north; at its east lies the Atlantic Ocean. As of the 2010...

. Such money was sold at a discount of silver, which the government would then spend, and would expire at a fixed point in time later. Bills of credit were controversial when they were first issued, and have remained controversial to this day. Those who have wanted to highlight the dangers of inflation have focused on the colonies where the bills of credit depreciated most dramatically – New England and the Carolinas. Those who have wanted to defend the use of bills of credit in the colonies have focused on the middle colonies, where inflation was practically nonexistent.

Colonial powers consciously introduced fiat currencies backed by taxes, e.g. hut tax
Hut tax
The hut tax was a type of taxation introduced by British colonialists in Africa on a per hut or household basis. It was variously payable in money, labour, grain or stock and benefited the colonial authorities in four related ways: it raised money; it supported the currency ; it broadened the cash...

es or poll tax
Poll tax
A poll tax is a tax of a portioned, fixed amount per individual in accordance with the census . When a corvée is commuted for cash payment, in effect it becomes a poll tax...

es, to mobilise economic resources in their new possessions, at least as a transitional arrangement.

The repeated cycle of deflationary hard money, followed by inflationary paper money continued through much of the 18th and 19th centuries. Often nations would have dual currencies, with paper trading at some discount to specie backed money. Examples include the “Continental” issued by the U.S. Congress before the Constitution
Constitution
A constitution is a set of fundamental principles or established precedents according to which a state or other organization is governed. These rules together make up, i.e. constitute, what the entity is...

; paper versus gold ducats in Napoleonic era Vienna
Vienna
Vienna is the capital and largest city of the Republic of Austria and one of the nine states of Austria. Vienna is Austria's primary city, with a population of about 1.723 million , and is by far the largest city in Austria, as well as its cultural, economic, and political centre...

, where paper often traded at 100:1 against gold; the South Sea Bubble, which produced bank notes not backed by sufficient reserves; and the Mississippi Company
Mississippi Company
The "Mississippi Company" became the "Company of the West" and expanded as the "Company of the Indies" .-The Banque Royale:...

 scheme of John Law
John Law (economist)
John Law was a Scottish economist who believed that money was only a means of exchange that did not constitute wealth in itself and that national wealth depended on trade...

.

During the American Civil War
American Civil War
The American Civil War was a civil war fought in the United States of America. In response to the election of Abraham Lincoln as President of the United States, 11 southern slave states declared their secession from the United States and formed the Confederate States of America ; the other 25...

, the Federal Government issued United States Note
United States Note
A United States Note, also known as a Legal Tender Note, is a type of paper money that was issued from 1862 to 1971 in the U.S. Having been current for over 100 years, they were issued for longer than any other form of U.S. paper money. They were known popularly as "greenbacks" in their heyday, a...

s, a form of paper fiat currency popularly known as 'greenbacks'. Their issue was limited by Congress at a little over $340 million. During the 1870s, withdrawal of the notes from circulation was opposed by the United States Greenback Party
United States Greenback Party
The Greenback Party was an American political party with an anti-monopoly ideology that was active between 1874 and 1884. Its name referred to paper money, or "greenbacks," that had been issued during the American Civil War and afterward...

. The term 'fiat money' was used in the resolutions of an 1878 party convention.

20th century


By World War I
World War I
World War I , which was predominantly called the World War or the Great War from its occurrence until 1939, and the First World War or World War I thereafter, was a major war centred in Europe that began on 28 July 1914 and lasted until 11 November 1918...

 most nations had a legalized government monopoly on bank notes and the legal tender status thereof. In theory, governments still promised to redeem notes in specie on demand. However, the costs of the war and the massive expansion afterward made governments suspend redemption in specie. Since there was no direct penalty for doing so, governments were not immediately responsible for the economic consequences of printing more money, which led to hyperinflation
Hyperinflation
In economics, hyperinflation is inflation that is very high or out of control. While the real values of the specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases...

 – for example in Weimar Germany
Weimar Republic
The Weimar Republic is the name given by historians to the parliamentary republic established in 1919 in Germany to replace the imperial form of government...

.

Attempts were made to reassert currency stability by anchoring it to wholesale gold bullion rather than making it payable in specie. This money combined pure fiat currency, in that the currency was limited to central bank notes and token coins that were current only by government fiat, with a form of convertibility, via gold bullion exchange, or via exchange into US dollars which were convertible into gold bullion, under the 1945 Bretton Woods system
Bretton Woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...

.

Bretton Woods



From 1944 to 1971, the Bretton Woods agreement fixed the value of 35 United States dollars to one troy ounce
Troy ounce
The troy ounce is a unit of imperial measure. In the present day it is most commonly used to gauge the weight of precious metals. One troy ounce is nowadays defined as exactly 0.0311034768 kg = 31.1034768 g. There are approximately 32.1507466 troy oz in 1 kg...

 of gold.

Other currencies were pegged to the U.S. dollar at fixed rates. The U.S. promised to redeem dollars in gold to other central banks. Trade imbalances were corrected by gold reserve exchanges or by loans from the International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...

. This system collapsed when the United States government ended the convertibility of the US dollar for gold in 1971, in what became known as the Nixon Shock
Nixon Shock
The Nixon Shock was a series of economic measures taken by U.S. President Richard Nixon in 1971 including unilaterally cancelling the direct convertibility of the United States dollar to gold that essentially ended the existing Bretton Woods system of international financial exchange.-Background:By...

.

Chartalism


Chartalism
Chartalism
Chartalism is a descriptive economic theory that details the procedures and consequences of using government-issued tokens as the unit of money. The name derives from the Latin charta, in the sense of a token or ticket...

 is a monetary theory that states the initial demand for a fiat currency is generated by its unique ability to extinguish tax liabilities. Goods and services are traded for fiat money due to the need to pay taxes in the money.

Loss of backing


A fiat-money currency generally loses value once the issuing government refuses to further guarantee its value through taxation, but this need not necessarily occur. For example, the so-called Swiss dinar
Swiss dinar
Swiss dinar is a term used to describe the Iraqi currency in circulation prior to the 1990 Gulf War with the Coalition Forces. The reason for the adjective "Swiss" is unknown, but there are two possible explanations. The first is that the printing plates for the currency came from Switzerland,...

 continued to retain value in Kurdish Iraq
Kurdistan Regional Government
The Kurdistan Regional Government , , is the official ruling body of the predominantly Kurds-populated Kurdistan Region in Northern Iraq...

 even after its legal tender status was withdrawn by its issuer, Iraq's central government.

Monetary economics


In monetary economics, fiat money is an intrinsically useless product, used as a means of payment. In some micro-founded models of money, fiat money is created internally
Endogeneity (economics)
In an econometric model, a parameter or variable is said to be endogenous when there is a correlation between the parameter or variable and the error term. Endogeneity can arise as a result of measurement error, autoregression with autocorrelated errors, simultaneity, omitted variables, and sample...

 in a community making feasible trades that would not otherwise be possible, either because producers and consumers may not anonymously write IOUs
IOU (debt)
An IOU is usually an informal document acknowledging debt. An IOU differs from a promissory note in that an IOU is not a negotiable instrument and does not specify repayment terms such as the time of repayment. IOUs usually specify the debtor, the amount owed, and sometimes the creditor...

, or because of physical constraints.

See also


  • Central Bank
    Central bank
    A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

  • European Central Bank
    European Central Bank
    The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...

    ; Federal Reserve
  • Friedman rule
    Friedman rule
    The Friedman rule is a monetary policy rule proposed by Milton Friedman. Essentially, Friedman advocated setting the nominal interest rate at zero. According to the logic of the Friedman rule, the opportunity cost of holding money faced by private agents should equal the social cost of creating...

  • Hard currency
    Hard currency
    Hard currency , in economics, refers to a globally traded currency that is expected to serve as a reliable and stable store of value...

  • Money illusion
    Money illusion
    In economics, money illusion refers to the tendency of people to think of currency in nominal, rather than real, terms. In other words, the numerical/face value of money is mistaken for its purchasing power...

  • Money supply
    Money supply
    In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

  • Seigniorage
    Seigniorage
    Seigniorage can have the following two meanings:* Seigniorage derived from specie—metal coins, is a tax, added to the total price of a coin , that a customer of the mint had to pay to the mint, and that was sent to the sovereign of the political area.* Seigniorage derived from notes is more...

  • Tinkerbell effect
    Tinkerbell effect
    The Tinkerbell effect is a term describing things that are thought to exist only because people believe in them. The effect is named for Tinker Bell, the fairy in the play Peter Pan who is revived from near death by the belief of the audience....

  • Value Theory
    Value theory
    Value theory encompasses a range of approaches to understanding how, why and to what degree people should value things; whether the thing is a person, idea, object, or anything else. This investigation began in ancient philosophy, where it is called axiology or ethics. Early philosophical...

  • Veil of money
    Veil of money
    Veil of money describes a problem in economics, which centers on the question of whether money is a commodity like other commodities, such as oil or gold or food - or whether it has special properties....

  • Fractional-reserve banking
    Fractional-reserve banking
    Fractional-reserve banking is a form of banking where banks maintain reserves that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction of the quantity of deposits as reserves...