Fiat money is a form of currency which is deemed valid and legal because the government says that it is, not because it is backed by a commodity such as gold or silver. The United States is one of the most prominent nations which relies on fiat money, although many other countries do as well. There are a number of advantages and disadvantages to this type of currency, and the issues with fiat money have been debated vigorously for centuries by economists and politicians.
The term “fiat” refers to a government decree. When a government creates fiat money, it declares that money produced by certain banks or mints is valid legal tender which will be accepted for all government debts, thereby making the currency legal. When the government is willing to accept a specific currency for payment of taxes and other government debts, this also means that everyone else in the society will be willing to accept it in exchange for goods and services. As a general rule, the money is minted by government-owned mints or banks, and it is marked with language which indicates that it is legal tender for both public and private debts.
Alternatives to fiat money include commodity currency, in which people exchange actual physical commodities like gold, and representative currency, in which each bill represents a set amount of a commodity, and it can be redeemed for that commodity. Historically, many nations had a gold or silver standard, in which currency was backed by government reserves of gold or silver, and citizens could walk into banks and ask to exchange their currency for its value in gold or silver. However, many nations turned away from representative currency to fiat money in order to cope with changing economic climates.
Fiat money is not self limiting, which can make nations which rely on this type of currency extremely vulnerable to hyperinflation. Citizens rely on their governments to make the right decisions about printing money and extending credit to ensure that their economies do not become inflated. When fiat money systems are abandoned, it is usually because hyperinflation has become such a huge problem that the economy falls apart.
There are some advantages to fiat money. The lack of self limiting measures on such currency can allow a government to rapidly expand the amount of funds it has in response to periods of economic growth, for example. No requiring backing with commodities can also free up government reserves of gold and silver because they no longer need to be retained and maintained.