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January 22, 2023

What Is Fiat Currency, How Does It Work, Examples, Pros & Cons

What Is Fiat Currency, How Does It Work, Examples, Pros & Cons

If you’ve started to delve into the cryptocurrency space or are interested in finance, you’ll likely have heard the term fiat currency. A term unfamiliar to most but is actually something a large proportion of the global population uses every day.

Fiat Currency Definition

Fiat currency is money issued by governments that are not backed by any physical commodity, such as gold, silver, or any other precious metals. Instead, it is backed by the government that issued it.

Traditionally, currency values were attributed to a commodity, such as the amount of gold held by a particular government. While some still operate this way, most don’t.

So, if there is nothing to tie the value of fiat currency to, how do we know what it is worth?

What Determines The Value of Fiat Currency?

To calculate the value of fiat currency there are many factors considered. Mainly supply and demand, as well as the stability of the government issuing it.

A complicated political climate, war, inflation, unemployment, and many other variables can impact the value of fiat currency.

The actions of a government drastically impact the value of fiat currency, and they are in control of supply, meaning they decide how much to print and when it’s printed.

Fiat Currency Examples

US Dollar – $

As of 1971, the gold-standard backing of the US dollar was scrapped. Since then, it has been a fiat currency held up by the US government. It is considered legal tender and is used by citizens and businesses, both public and private.

Euro – €

The Euro is legal tender and fiat currency for those member states that have opted to use the currency. There are many social, economic, and geographical factors in play with the Euro because multiple countries are all contributing to its overall worth and value.

Pros & Cons Of Fiat Currency

Pros

Governments and central banks opted to introduce fiat currency as a way of protecting their economies from the natural business cycle and giving the population a stable means of completing transactions.

As its value isn’t tied to any store of commodity, it makes fiat currency much more cost-efficient to manage and produce. Furthermore, it enables banks to control the supply of money and how much is printed. Therefore, they can prevent inflation and hyperinflation – although that isn’t always the case.

Cons

The global market crash, recession, and economic meltdown of 2007 and 2008 cast doubt over the ability of governments, banks, and fiat currency to protect us against such depressions. As fiat isn’t tied to a commodity such as gold, its value fluctuates more. Also, as it has an unlimited supply, we’re placing much confidence in decision-makers to print to the correct amount to avoid negative implications.

With commodity-backed currency, the worth is determined by the value of the said commodity which is limited in supply.

Fiat Currency Vs. Cryptocurrency

Ok, we’ve already busted the myth that fiat currency isn’t backed by gold or any other commodity, so what’s the difference between fiat and crypto?

As discussed, fiat currency is issued and controlled by governments and banks. To perform transactions, everyone requires a middleman to facilitate the process, meaning individuals retain little control and are reliant on governments.

On the other hand, cryptocurrency is a digital asset that gets its value from the native blockchain it is hosted on. Rather than handing power to the government and requiring financial institutions as intermediaries, crypto uses a peer-to-peer model. This allows individuals and businesses to complete transactions using the governance of blockchain protocols, code, and communities.

Digital Fiat Currency

The rise of technology and the introduction of digital currency can make drastic improvements to the existing financial system. Some governments are exploring the idea of introducing central bank digital currencies. These currencies will act much like fiat currency and will be backed by the fiat currency of a country.

Essentially, the mission of central bank digital currencies is to provide and promote financial inclusion and simplify the transaction process. It also enables every transaction to be logged, tracked, and approved, giving people better security and easier access to financial services.

However, one thing CBDCs won't provide is the anonymity the crypto offers.

In Summary

Fiat currencies currently power the worldwide economic ecosystem. They aren’t backed by a commodity, meaning their value is determined by the trust in the government that issues them. This provides greater flexibility and enables governments to cost-effectively produce money. However, with no physical source of value to underpin them, they can be volatile and reactionary to the actions of governments. This is where we see inflation and hyperinflation.

Now, we’re seeing the rise of cryptocurrencies, challenging the fiat currency and cefi system. The introduction of decentralized finance takes control away from governments and gives it back to people, protecting anonymity while providing currencies everyone can transact in.

However, governments are seeing the benefits of the rise in digital. They’re exploring and introducing their own digital fiat-backed currencies. How do you think the future of finance will look? Is it going to be centralized, decentralized, or both?

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