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Fiat money is a form of currency that is backed by the government that issued it rather than a physical good like gold or silver. Instead of having backing in the form of a valuable commodity, fiat money derives its value from the interaction of supply and demand and the stability of the government that issues it. The U.S. dollar, the euro, and other significant world currencies are among the majority of contemporary paper money.
The Latin word "fiat" is frequently translated as "it shall be" or "let it be done." Fiat money is therefore useless in and of itself; it only has value when the government upholds it. Governments used to print paper money that could be exchanged for a predetermined amount of tangible commodities or make coins out of valued physical commodities like gold or silver before the invention of fiat money. But because there is no underlying asset supporting fiat, it is not convertible and cannot be redeemed.
Fiat money has the benefit of giving central banks more economic control because they can decide how much money is issued. As a result, they can modify the money supply to affect interest rates, inflation, and economic growth. For instance, the central bank can boost the money supply during a recession to encourage investment and spending, while it can decrease the money supply during an inflationary period to prevent price increases.
Fiat money has the potential to lose value owing to inflation or possibly lose all of its value in the event of hyperinflation. When the costs of goods and services increase over time, the purchasing power of money is reduced, and inflation results. When inflation spikes to exceptionally high and unmanageable levels, a loss of trust in the currency's value and ability to serve as a medium of exchange results. This is known as hyperinflation. One factor that contributes to hyperinflation is when governments print an excessive amount of money to pay their spending, exceeding the amount that is needed.
Some examples of hyperinflation in history are:
- The Weimar Republic in Germany after World War I, when the government printed money to pay reparations to the Allies, resulting in a peak inflation rate of 29,500% per month in 1923.
- Zimbabwe in 2008, when the government printed money to fund its budget deficit and fight political opponents, resulted in a peak inflation rate of 79.6 billion per month in November 2008.
- Venezuela in 2018-2019, when the government printed money to cope with falling oil prices and U.S. sanctions, resulting in a peak inflation rate of 10 million per year in 2019.
People lost trust in their national currencies in these situations and turned to alternate forms of payment like foreign currencies, gold, or cryptocurrency.
Fiat money may also depreciate if its issuer government or its capacity to uphold stability and sovereignty is questioned. People could question the legitimacy or stability of the government and its currency, for instance, amid political or social turmoil, conflict, or regime change. This may cause investors to flee native currencies in favor of safer ones.
Governments and central banks must implement good monetary policies that balance the supply and demand of money, uphold price stability, and promote economic growth in order to avoid or reduce these dangers. Additionally, they must maintain fiscal restraint and stay away from deficits and excessive debt that could jeopardize their solvency and legitimacy. Additionally, they must respect the rule of law and defend the contracts and property rights that support a market economy.
Modern economies depend on fiat money, which permits cross-border and cross-sector transactions and exchanges. However, it also comes with difficulties and obligations for both governments and the people who utilize it as a measure of value and a means of exchange.
