Fiat Currency - What is Fiat/Paper Money?

We use fiat currency everyday, all across the monetary system, but many people don’t fully understand what it is or why it exists. In this blog, we explain what fiat money is, the history and evolution of fiat currencies, why society needs money, and the pros and cons of fiat currencies.

What is fiat money?

Fiat money is a type of currency that’s not backed by a physical commodity like gold or silver. It simply has value because a government says it does. The British pound, U.S. dollar, Japanese yen, and most other national currencies used today are all examples of fiat money.

The word fiat comes from Latin and roughly translates to ‘let it be done’. In other words, its value exists because the issuing government declares it legal tender and people trust that declaration.

Unlike physical commodities, fiat money has no intrinsic value. You can’t melt a banknote down into something useful, its power comes entirely from:

• Government backing
• Public trust
• Supply-and-demand dynamics
• A functioning economy.

Because it’s not tied to national reserves, like gold or silver, fiat money can lose its value through inflation and even become worthless.

Before fiat money, governments would mint coins out of a valuable physical commodity like gold or silver, giving the currency intrinsic value. In these earlier systems, paper notes represented a claim on precious metals stored in government vaults, and people could redeem their notes for physical gold or silver. Fiat money, however, is inconvertible and cannot be exchanged because it’s not backed by any underlying commodity.

Why does fiat money have value?

Fiat currency only works because people collectively agree to use it. This agreement rests on three things:

1. Legal tender laws: Governments require their currency to be accepted for debts, taxes, and payments
2. Trust in institutions: People believe the government will uphold the value of the money
3. Economic stability: A strong, functioning economy reinforces that trust.

If this trust breaks down, then the value of fiat money can fall quickly. We’ve seen this in the past, like Hungary in 1946 or Zimbabwe in the late 2000s, where hyperinflation destroyed these currency’s purchasing power almost overnight.

See: Exploring the Role of Gold as an Effective Hedge Against Inflation

Fiat vs. representative vs. commodity money

Money can be classified into three categories: commodity money, fiat money, and representative money.

Commodity money

Commodity money is money with inherent value. It’s the oldest financial instrument and includes things like gold coins, silver coins, and salt, tobacco, beads, or seashells used in early societies.

Unlike forms of money we see today, commodity money has a tangible store of value. You can use the actual money itself (e.g. using gold for jewellery), giving it intrinsic worth.

Fiat money

Fiat currency’s value comes from government backing and public confidence. So long as individuals and people have faith in their government, they’ll have faith in the currency.

Fiat money is also inconvertible and cannot be redeemed for gold, silver, or any other commodity.

Representative money

Representative money is a financial instrument that’s backed by a commodity or fiat currency, such as a cheque, credit card, or silver certificate. Like fiat money, representative money has no value of its own – its value comes from the backing asset and the financial institutions that uphold it.

A brief history of fiat currency

Fiat currency emerged gradually as governments looked for more flexible and practical ways to manage trade, stabilise economies, finance wars, and support growing populations. You can break down the evolution of fiat currency into four eras:

The age of commodity money

For thousands of years, societies used commodity money which had inherent value. This included gold and silver coins, copper ingots, cowrie shells, and even salt, grain, or tobacco. The value of these items came from their usefulness or scarcity – for example, a gold coin was valuable because gold itself is valuable.

However, there were some limitations to commodity money. Precious metals were heavy and difficult to transport. They were also hard to secure, especially for growing economies with expanding trade routes.

Keep Reading: What Drives the Price of Gold?

Early representative money and the rise of paper

As trade increased around the world, it became impractical to carry large amounts of metal. To solve this, ancient merchants and governments started issuing representative money. These were paper notes redeemable for precious metals, a kind of early version of the modern banknote we use today.

China was one of the first places to use paper currency, during the Tang and Song dynasties of the 7th to 11th centuries. These notes were authorised by the government and could be exchanged for metal coins later. Europe and the U.S. adopted similar systems much later on, particularly in the 17th to 19th centuries.

Representative money made trade easier, but it still relied on governments holding large reserves of gold or silver. When these reserves fell, or if a government issued too many notes, a crisis would follow.

The global gold standard

By the time of the 1800s, many countries were committed to the gold standard. In this system, currencies could be freely exchanged for a fixed amount of gold. Under the gold standard:

• Each unit of currency represented a specific weight of gold
• Governments had to hold enough gold to match their money supply
• Exchange rates between countries were fixed.

This system helped stabilise currencies but it also limited flexibility. Because the amount of money in circulation depended on gold reserves, countries couldn’t easily expand their monetary supply during recessions or emergencies. This proved to be an issue during World War 1, and so many nations suspended their gold convertibility in order to finance military spending.

The collapse of the gold standard

After WW1, many countries tried to return to the gold standard, but it was near impossible due to economic devastation and dwindling reserves. In 1931, the UK abandoned gold entirely, and during the Great Depression, more and more countries abolished the standard. To stabilise their economies, governments needed more freedom to adjust money supply, and the gold standard didn’t allow for that.

After WW2, world leaders met in Bretton Woods, New Hampshire to design a more flexible system. Their solution was a hybrid system where:

• Global currencies were pegged to the U.S. dollar
• The U.S. dollar was pegged to gold at $35 an ounce
• Countries held dollars as their main reserve asset.

However, this system began to falter as the U.S. spent heavily on the Vietnam War and other nations doubted America’s ability to redeem dollars for gold. By the early 1970s, it was clear that the U.S. didn’t have enough gold to back all the dollars circulating around the world.

In August 1971, President Richard Nixon suspended the dollar’s convertibility into gold, ending the Bretton Woods system and removing the last tie between major currencies and gold. This forced currencies to float, which means their value depended on supply and demand.

Within two years, the world had transitioned to a fully fiat-based system. The Swiss franc was the last major currency to give up gold backing and finally went fiat in 2000.

Learn More: Bretton Woods Agreement and the Institutions it Created, Explained

Why do we need money?

Money exists because it makes trade much easier. Before we used money, people relied on bartering, which only works in small communities and starts to lose its benefits when a society or population grows.

Bartering requires a double coincidence of wants – you need to want what the other person is offering, and they need to want what you're offering. This doesn’t always happen. For example, a fisherman might want shoes but if the shoemaker doesn’t want fish, the trade can’t happen. Money solves this problem: the fisherman can sell the fish to someone who wants it, receive money, and use that money to buy shoes.

Money also creates trust between strangers. In small communities, people can rely on relationships and reputation, but this trust breaks down in larger societies like towns or cities (or international trade). In these situations, money acts as a universal trust system: sellers trust the value of money and buyers trust they can spend it later. This eliminates the need to trust every person you transact with, which is practically impossible in our modern and globalised society.

Pros and cons of fiat currency

Advantages of fiat currency

Some of the pros of using fiat currency include:

• More economic flexibility: Because fiat money’s supply isn’t tied to a fixed, scarce resource like gold, it gives central banks more control over interest rates, credit supply, and liquidity in financial markets. This gives policymakers more flexibility to support the economy during recessions or unexpected financial shocks.
• Easier to produce: Fiat money is cheap to produce compared to commodity-backed currency. This gives it great seigniorage – the difference between the cost of printing money and its face value.
• Supports modern financial systems: Today’s global economy, with its electronic payments, mortgages, and credit markets, couldn’t function under a strict gold standard. Fiat money allows for large-scale lending, digital payments, and flexible credit creation.

Disadvantages of fiat money

Some of the cons of using fiat currencies include:

• Risk of mismanagement: Governments can issue new currency when they want, which can lead to high inflation, currency devaluation, and hyperinflation in extreme cases.
• No intrinsic value: Fiat money has no physical value. If public trust in the system collapses, the currency can lose its value quickly.
• Encourages overspending: Physical currencies restrict how much money can be created because currencies are tied directly to gold reserves. This limits government spending and reduces the risk of long-term inflation. The flexibility of fiat systems removes these limits and encourages overspending.

Similar Reading: Why Central Banks Buy Gold

Examples of fiat money

Nearly every national currency in the world today is an example of fiat money, including the British pound, euro, U.S. dollar, Japanese yen, Indian rupee, and so on. Some currencies, like the Canadian dollar or Russian ruble, are heavily influenced by commodity prices (e.g. oil), but they’re still considered fiat money because they cannot be redeemed for a physical commodity.

FAQ: Fiat currency

What makes fiat currency valuable?

Fiat money has value because people trust the government that issues it, and because the government demands that people pay taxes in the fiat money it issues.

Does fiat money cause hyperinflation?

Fiat money can contribute to hyperinflation, but it’s not the only cause. Hyperinflation usually happens after major economic or political breakdowns, and it has even been seen throughout history when money’s value was tied to precious metals.

What are some alternatives to fiat money?

Alternatives to fiat money include cryptocurrencies like Bitcoin, and gold or other precious metals (used for investment and not everyday transactions).

See: Gold vs Bitcoin: Which is the Better Hedge?

Why don’t all countries use the same money?

If all countries used the same money, it would make it harder for nations to run their own monetary policy, adjust interest rates, and respond to economic shocks. The reason this works within the eurozone is because those countries’ economies have similar features.

What happens when a fiat currency collapses?

When people lose trust in a fiat currency, its value quickly erodes. In these situations, people often switch to foreign currencies like the U.S. dollar.