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What is a fiat currency?

A fiat currency is a national currency that is not linked to the value of a solid commodity such as gold, silver or platinum. It therefore follows that the value of fiat money is largely based on the credibility of the specific country’s central bank, which issues the currency.

The difference between fiat money and commodity issue money relates to their value, with commodity money linking to the materials it is made of, such as gold and silver coins. Fiat money by contrast, has no fundamental value – it is basically a promise from a government or central bank that the currency is can be exchanged for goods and services to its equivalent value.

Examples of a fiat currency

Well-known examples of fiat currencies include the pound, the euro and the US dollar. In fact, very few world currencies are true commodity currencies and most are, in one way or another, a form of fiat money.

Advantages and disadvantages of a fiat currency

Pros

Since fiat money is not a scarce or fixed resource – like gold – a country’s central bank has greater control over its supply and value. This means that governments can manage the credit supply, liquidity and interest rates more reliably.

Unlike commodity currencies, which could be affected by the discovery of a new gold mine, the supply of fiat currencies is regulated and controlled by the respective currency’s government. There is less risk of an unexpected devaluation caused by the supply of fiat currencies, as any increase in supply is a pre-empted decision made by a fiat currency’s government.

Cons

Since it is not tied to a touchable asset, the value of fiat money is dependent on the stability of the fiscal policy of the particular government in question. Irresponsible policies in this area can lead to inflation and even hyperinflation of a fiat currency.

Adding to this, there is greater chance for bubbles with fiat currency – an economic cycle in which there is a rapid increase in price before an equally quick fall.

The increased occurrence of bubbles is due to fiat currencies having a virtually unlimited supply, which means that quantitative easing is an option. This can also cause greater inflation rates. This could impact anything from housing prices to national debt levels, which in turn could impact the financial markets.

The future…

Despite the increasing popularity of the digital form of fiat currency, cryptocurrencies also stand out as a means of legal tender regardless of jurisdiction. However, whilst there are many advantages of cryptocurrencies over fiat money, it seems that cryptocurrencies are not yet mature enough in their journey to replace the current standard payment method. Indeed, the crypto market will most likely develop alongside the current money system, instead of completely replacing it.

A major difference in these financial vehicles links to volume or supply. Fiat money has an unlimited supply which means central authorities have no cap to the extent in which they can produce money.

With cryptocurrencies, there is a set amount of coins that will ever be in supply – illustrating this is the fact that the total number of Bitcoin coins that will ever be in supply is capped.

With fiat money, it is impossible to tell the amount of money in circulation at any given time, but with cryptocurrencies, it is possible. This, in turn, demonstrates the viability of both systems successfully running alongside each other in future.