What Is Fiat Currency? And Its Pros and Cons

You would have probably heard your grandparents say that a 25-paisa metal coin could get them one or two kilograms of rice during their childhood. When you asked your parents how much a kilo of rice cost while they were kids, they would answer that they could buy one or two kilos of rice with a INR 2 metal coin. Today, maybe, we can buy a kilo or two of rice with a INR 50 paper note or pay that price digitally.

The prices of commodities and services increase over time. However, it is not because the service or the product’s value is rising but because of the gradual erosion of our currency’s value. One of the significant reasons is inflation, which is beyond this article’s scope.

Anyway, have you ever wondered how the price of a single product or service has taken different shapes and sizes over the decades? For example, 25 paisa coins were small and round in shape. On the other hand, INR 2 metal coins are round but more oversized. And when it comes to INR 50, they are not circular metal coins but a rectangular piece of paper or a credit card swipe.

Here we discuss how currencies have evolved and exist as it is today. We also look at how a single piece of paper can hold monetary value and what backs its value.

The Fiat Currency

Fiat currency is money with no intrinsic value but is accepted by a government as legal tender. Historically, paper currencies are backed by physical yet precious commodities like gold and silver, but the fiat currency hinges on the issuing government’s trustworthiness.

Fiat currency was invented as a substitute for commodity and representational money. Commodity money gets its value from precious metals like gold and silver, whereas representative money is a claim on a monetary reserve or a commodity. On the other hand, the value of fiat currency is derived from its supply and demand.

China introduced the first fiat currency in the world around 1000 CE, and it spread across the globe in no time. Fiat currency gained worldwide prominence when US President Richard Nixon removed the gold standard in 1971. Most countries use fiat paper currencies with tight control over counterfeiting and money supply.

Pros Of Fiat Currency

Fiat currency comes with several advantages, and a few prominent ones are mentioned below.

Unlike commodity and representative money, which are volatile due to the business cycles and price fluctuations of underlying assets, fiat currency has a consistent value. As a result, a country’s central bank can produce or keep paper money as per the need of their economy, giving them complete control over the money supply, interest rates, and liquidity.

Fiat currency is a highly valued and widely accepted cash all over the globe as it is received by various currency exchanges and payment networks.

Since governments have complete control over the fiat money supply and are not based on volatile commodities, it keeps a country’s economy stable.

Cons Of Fiat Currency

Similar to pros, fiat currency also has cons, and some of the significant ones are mentioned below.

Although fiat currency is widely considered a more stable currency, particularly during a recession, critics argue that currency based on gold with a limited supply has better stability than fiat currency with an unlimited supply.

When a country’s economy faces a recession, or people lose trust in a government, fiat currency may lose its value to zero.

Since the power to produce or print fiat currency vests with the government, it can steal the citizens’ purchasing power even if they refuse to pay taxes. During such an instance, the government will slightly increase the fiat currency supply and then purchase whatever they need before the increase in money supply takes its toll on the rise in prices.

The government is compelled to issue new banknotes to replace the lost or damaged currency no longer in circulation. Sometimes, it creates more money than needed leading to the loss of value of fiat currencies.

Fiat Currency Vs Crypto Currency

Comparing them with fiat currency will do good when the world is standing on the brink of embracing the new age economy driven by digital assets like cryptocurrencies and Non-Fungible Tokens (NFTs).

As you have seen, fiat currency is a legal tender or a currency considered legitimate and valued by a government and people worldwide. On the other hand, Cryptocurrency is a decentralised digital currency not backed by a government or any central authority.

But there is an advantage to Cryptocurrency. Both fiat and cryptocurrencies are not based on any underlying assets. Still, cryptocurrencies use blockchain technology, making counterfeiting by anti-social elements or unlimited printing by a central authority nearly impossible. In addition, although cryptocurrencies are highly volatile, it offers a high level of security.

The recent widespread acceptance of cryptocurrencies is a sign that they will soon replace fiat currencies for our financial transactions.

Wrapping It Up

Fiat currency or paper money arrived in the world of finance as a storage medium of our purchasing power and something that could eliminate the inefficiencies of the barter system. It allows us to purchase what we require without exchanging commodities or metal coins for the products or services we need. Moreover, because of its flexibility to store and transfer purchasing power, anyone can use it for specific economic activities.

As you have seen, governments have complete control over the fiat currency supply, which has no intrinsic value, and its value is determined by market forces of demand and supply. However, despite governments’ complete control over fiat currency supply, they must exercise extreme caution while producing or printing fiat currency. If not, the fiat currency’s value may fall due to over-circulation, leading to hyperinflation.

The stability of a country’s economy, governance, and the impact of these factors on interest rates affect fiat currency’s value. Political and economic instability is likely to weaken fiat currency’s value and increase the costs of products and services.

To cut a long story short, fiat money runs successfully as a storage medium of purchasing power on the firm belief of a country’s citizens in their country’s political and economic stability. It is also based on their faith that the fiat currency satisfies all their financial transactions. If that long-held faith is lost, it marks the end of a fiat currency.

(The writer is a Partner at Alpha Capital)