Fiat currency Totally Explained

Everything about Fiat Money totally explained

In economics, fiat currency or fiat money is money that has value primarily because a government demands it in payment of taxes, and that government has credible enforcement of its demand.
The taxing government's choice of the form or origin of money it accepts may be somewhat arbitrary, but the unifying feature of all fiat money is that whatever form or origin, the market demand for it's dominated by the taxing government's demand for it in payment of taxes. For example, a coin may be considered fiat currency if its face value -- the value it has in payment of taxes -- is higher than its market value as metal. The term “fiat” money has been used to distinguish such money from representative money, which is pegged or fixed to a quantity or mass of precious metal. While representative money is often associated with a legal requirement that the bank of issue pay in fixed weights of a given precious metal or (in theory) fixed amount of any other precious good, fiat money's value is fixed only to its value in transactions controlled by government authority, such as taxation.
Fiat money is a subset of general credit money, but a special one in which a government, often through a central bank or reserve bank, has taken the responsibility (monetary authority) of being the major creditor backing the currency. An economy may function on credit money which is not fiat money, such as United States paper currency during periods when the U.S. didn't have a central bank, or the banknotes of the Scottish clearing banks, which function in Scotland as currency, even though not backed by the government of Scotland. Usually, a fiat-money currency loses value once the government which acts as the creditor refuses to further guarantee its value through taxation, but a strong private banking system and consensus of the population may prevent this. For example, the so-called Swiss dinar continued to retain value as a type of credit money in Kurdish Iraq, as a result of backing by private banks and acceptance from individuals there, even after its fiat-money status was officially completely withdrawn by the backing government (the central government of Iraq).
Among many people who advocate for specie, such as gold, silver or a bimetallic standard, the term 'fiat money' is often used as a pejorative term.

History

The first historical example of paper as fiat money was in China. Chinese governments would produce “notes of credit” which were valued as tender for limited periods of time, in order to prevent inflation. The Song Dynasty (960–1279), however, created unlimited legal tender paper money, good throughout their empire, as a way of centralizing financial control, and preventing external trade. This money, however, was only as stable as the mandarinate that enforced it, and only as safe as the rigidity and integrity of the people who created it. Since it was easy to counterfeit and communication was slow, the Song experiment with paper money collapsed, as individuals preferred doing business through bank drafts or cheques, which were backed with gold or silver.

19th century

In the 19th century, increasing international trade made monetary standards based on more than one kind of specie gradually less stable, as individuals could engage in arbitrage, buying silver where it was cheap, and then redeeming it for gold where it was overvalued. This led to the gradual adoption of the gold standard among industrialized nations. While exact dates are often hard to fix, Britain’s adoption of the gold sovereign in 1816 began its move to a gold standard, and 1844 is generally dated as the establishment of the practical gold standard in the United Kingdom. Previously, silver had been the standard against which gold was measured, because Europe had had an influx of silver from mines in Germany and silver looted from the Inca and Aztec empires and because silver had been more readily available than gold in Europe during the Middle Ages.
An early form of fiat currency were "bills of credit." Provincial governments produced notes which were fiat currency, with the promise to allow holders to pay taxes in those notes. The notes were issued to pay current obligations and could be called by levying taxes at a later time. Since the notes were denominated in the local unit of account, they were circulated from man to man in non-tax transactions. These types of notes were issued in the British colonies in America, particularly in Pennsylvania, Virginia and Massachusetts. Most of the confusion centers around two meanings of convertibility:

Physical convertibility: Units of currency can be presented to the issuing bank in exchange for a physical amount of gold, silver, or some other commodity. ; Financial convertibility: Units of currency can be returned to the issuing bank in exchange for that unit's worth of the bank’s assets.
The importance of financial convertibility can be seen by imagining that people in a community one day find themselves with more paper currency than they wish to hold — for example, when the Christmas shopping season has ended. If the local currency unit is physically convertible (for one ounce of silver, let us suppose), people will return the unwanted currency units to the bank in exchange for silver, but the bank could head off this demand for silver by selling some of its own bonds to the public in exchange for its own paper units. For example, if the community has $100 of unwanted paper money, and if people intend to redeem the unwanted $100 for silver at the bank, the bank could simply sell $100 worth of bonds or other assets in exchange for $100 of its own paper dollars. This will soak up the unwanted paper and head off peoples’ desire to redeem the $100 for silver. [Thesymbol $ is used here as a generic currency unit], Thus, by conducting this type of open market operation — selling bonds when there's excess currency and buying bonds when there's too little — the bank can maintain the value of the dollar at one ounce of silver without ever redeeming any paper dollars for silver. In fact, this is essentially what all modern central banks do, and the fact that their currencies might be physically inconvertible is made irrelevant by the maintenance of financial convertibility. Note that financial convertibility can't be maintained unless the bank has sufficient assets to back the currency it has issued. Thus, it's an illusion that any physically inconvertible currency is necessarily also unbacked.
However, the financial assets obtained from such transactions only have derivative value from their yield of fiat currency, or from yet other financial assets. Therefore the integrity of the financial system requires that there be a different ultimate form of backing, such as the acceptability of the fiat currency in payment of tax.

Further Information

Get more info on 'Fiat Money'.

External Link Exchanges

Do you know how hard it is to get a link from a large encyclopaedia? Well we're different and will prove it. To get a link from us just add the following HTML to your site on a relevant page:

<a href="http://fiat_currency.totallyexplained.com">Fiat currency Totally Explained</a>

Then simply click through this link from your web page. Our crawlers will verify your link, extract the title of your web page and instantly add a link back to it. If you like you can remove the words Totally Explained and embed the link in article text.
As long as your link remains in place, we'll keep our link to you right here. Please play fair - our crawlers are watching. Your site must be closely related to this one's topic. Any kind of spamming, dubious practises or removing the link will result in your link from us being dropped and, potentially, your whole site being banned.