Fiat money

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Yuan dynasty banknotes are a medieval form of fiat money. Yuan dynasty banknote with its printing plate 1287.jpg
Yuan dynasty banknotes are a medieval form of fiat money.

Fiat money is a currency without intrinsic value that has been established as money, often by government regulation. Fiat money does not have use value, and has value only because a government maintains its value, or because parties engaging in exchange agree on its value. [1] It was introduced as an alternative to commodity money and representative money. Commodity money is created from a good, often a precious metal such as gold or silver, which has uses other than as a medium of exchange (such a good is called a commodity). Representative money is similar to fiat money, but it represents a claim on a commodity (which can be redeemed to a greater or lesser extent). [2] [3] [note 1]

A currency, in the most specific sense is money in any form when in use or circulation as a medium of exchange, especially circulating banknotes and coins. A more general definition is that a currency is a system of money in common use, especially for people in a nation. Under this definition, US dollars (US$), pounds sterling (£), Australian dollars (A$), European euros (€), Russian rubles (₽) and Indian Rupees (₹) are examples of currencies. These various currencies are recognized as stores of value and are traded between nations in foreign exchange markets, which determine the relative values of the different currencies. Currencies in this sense are defined by governments, and each type has limited boundaries of acceptance.

In commodity money, intrinsic value can be partially or entirely due to the desirable features of the object as a medium of exchange and a store of value. Examples of such features include divisibility; easily and securely storable and transportable; scarcity; and difficulty to counterfeit. When objects come to be used as a medium of exchange they lower the high transaction costs associated with barter and other in-kind transactions.

A monetary system is the set of institutions by which a government provides money in a country's economy. Modern monetary systems usually consist of the national treasury, the mint, the central banks and commercial banks.

Contents

Government issued banknotes began to be used in 11th century China. Since then, they have been used by various countries, usually concurrently with commodity currencies. Fiat money started to dominate in the 20th century. Since the decoupling of the US dollar from gold by Richard Nixon in 1971, a system of national fiat currencies has been used globally.

Banknote Form of physical currency made of paper, cotton or polymer

A banknote is a type of negotiable promissory note, made by a bank, payable to the bearer on demand. Banknotes were originally issued by commercial banks, which were legally required to redeem the notes for legal tender when presented to the chief cashier of the originating bank. These commercial banknotes only traded at face value in the market served by the issuing bank. Commercial banknotes have primarily been replaced by national banknotes issued by central banks.

Nixon shock 1971 decoupling of the US dollar from gold

The Nixon shock was a series of economic measures undertaken by United States President Richard Nixon in 1971, in response to increasing inflation, the most significant of which were wage and price freezes, surcharges on imports, and the unilateral cancellation of the direct international convertibility of the United States dollar to gold.

Fiat money has been defined variously as:

Legal tender is a medium of payment recognized by a legal system to be valid for meeting a financial obligation. Paper currency and coins are common forms of legal tender in many countries. Legal tender is variously defined in different jurisdictions. Formally, it is anything which when offered in payment extinguishes the debt. Thus, personal cheques, credit cards, and similar non-cash methods of payment are not usually legal tender. The law does not relieve the debt obligation until payment is tendered. Coins and banknotes are usually defined as legal tender. Some jurisdictions may forbid or restrict payment made other than by legal tender. For example, such a law might outlaw the use of foreign coins and bank notes or require a license to perform financial transactions in a foreign currency.

Fiduciary person who takes care of money for another person or organization

A fiduciary is a person who holds a legal or ethical relationship of trust with one or more other parties. Typically, a fiduciary prudently takes care of money or other assets for another person. One party, for example, a corporate trust company or the trust department of a bank, acts in a fiduciary capacity to another party, who, for example, has entrusted funds to the fiduciary for safekeeping or investment. Likewise, financial advisers, financial planners, and; asset managers, including managers of pension plans, endowments, and other tax-exempt assets, are considered fiduciaries under applicable statutes and laws. In a fiduciary relationship, one person, in a position of vulnerability, justifiably vests confidence, good faith, reliance, and trust in another whose aid, advice, or protection is sought in some matter. In such a relation good conscience requires the fiduciary to act at all times for the sole benefit and interest of the one who trusts.

A fiduciary is someone who has undertaken to act for and on behalf of another in a particular matter in circumstances which give rise to a relationship of trust and confidence.

The term fiat derives from the Latin fiat ("let it be done") [8] used in the sense of an order, decree [2] or resolution. [9]

Treatment in economics

In monetary economics, fiat money is an intrinsically valueless object or record that is widely accepted as a means of payment. [3] [ not in citation given ] In some micro-founded models of money, fiat money is created internally in a community making feasible trades that would not otherwise be possible, either because producers and consumers may not anonymously write IOUs, or because of physical constraints. [10] [11]

Monetary economics is the branch of economics that studies the different competing theories of money: it provides a framework for analyzing money and considers its functions, and it considers how money, for example fiat currency, can gain acceptance purely because of its convenience as a public good. The discipline has historically prefigured, and remains integrally linked to, macroeconomics. This branch also examines the effects of monetary systems, including regulation of money and associated financial institutions and international aspects.

In econometrics, endogeneity broadly refers to situations in which an explanatory variable is correlated with the error term. The distinction between endogenous and exogenous variables originated in simultaneous equations models, where one separates variables whose values are determined by the model from variables which are predetermined; ignoring simultaneity in the estimation leads to biased estimates as it violates the exogeneity assumption of the Gauss–Markov theorem. The problem of endogeneity is unfortunately, oftentimes ignored by researchers conducting non-experimental research and doing so precludes making policy recommendations. Instrumental variable techniques are commonly used to address this problem.

Precious metals

Circulating silver coins in the 1960s ceased to be produced containing the precious metal when the face value of the coin was below the cost of the elemental metal. The Coinage Act of 1965 eliminated silver from the circulating dimes and quarter dollars of the United States, and most other countries did the same with their coins. [12]

Silver coins are possibly the oldest mass-produced form of coinage. Silver has been used as a coinage metal since the times of the Greeks; their silver drachmas were popular trade coins. The ancient Persians used silver coins between 612-330 BC. Before 1797, British pennies were made of silver.

Face value value of a coin, stamp or paper money, as printed on the coin, stamp or bill itself by the minting authority

The face value is the value of a coin, stamp or paper money, as printed on the coin, stamp or bill itself by the issuing authority. The face value of coins, stamps, or bill is usually its legal value. However, their market value need not bear any relationship to the face value. For example, some rare coins or stamps may be traded at prices considerably above their face value.

Coinage Act of 1965

The Coinage Act of 1965, Pub.L. 89–81, 79 Stat. 254, enacted July 23, 1965, eliminated silver from the circulating United States dime and quarter dollar coins. It also reduced the silver content of the half dollar from 90 percent to 40 percent; silver in the half dollar was subsequently eliminated by a 1970 law.

The Canadian penny was mostly copper until 1996 and was removed from circulation in the fall of 2012 due to the cost of production relative to face value. [13]

In 2007 the Royal Canadian Mint produced a million dollar gold bullion coin and sold five of them. In 2015, the gold in the coins was worth more than 3.5 times the face value. [14]

History

China

China has a long history with paper money, beginning in the 7th century. In the 11th century, the government established a monopoly on its issuance, and around the turn of the 12th century, convertibility was suspended. [15] The use of such money became widespread during the subsequent Yuan and Ming dynasties. [16]

Song Dynasty Jiaozi, the world's earliest paper money. Jiao zi.jpg
Song Dynasty Jiaozi, the world's earliest paper money.

The Song Dynasty in China was the first to issue paper money, jiaozi , around the 10th century AD. Although the notes were valued at a certain exchange rate for gold, silver, or silk, conversion was never allowed in practice. The notes were initially to be redeemed after three years' service, to be replaced by new notes for a 3% service charge, but, as more of them were printed without notes being retired, inflation became evident. The government made several attempts to support the paper by demanding taxes partly in currency and making other laws, but the damage had been done, and the notes fell out of favor. [17]

The successive Yuan Dynasty was the first dynasty in China to use paper currency as the predominant circulating medium. The founder of the Yuan Dynasty, Kublai Khan, issued paper money known as Chao in his reign. The original notes during the Yuan Dynasty were restricted in area and duration as in the Song Dynasty.

During the 13th century, Marco Polo described the fiat money of the Yuan Dynasty in his book The Travels of Marco Polo . [18] [19]

All these pieces of paper are issued with as much solemnity and authority as if they were of pure gold or silver... and indeed everybody takes them readily, for wheresoever a person may go throughout the Great Kaan's dominions he shall find these pieces of paper current, and shall be able to transact all sales and purchases of goods by means of them just as well as if they were coins of pure gold.

Marco Polo, The Travels of Marco Polo

Europe

Washington Irving records an emergency use of paper money by the Spanish in a siege during the Conquest of Granada (1482–1492). In 1661, Johan Palmstruch issued the first regular paper money in the West, under royal charter from the Kingdom of Sweden, through a new institution, the Bank of Stockholm. While this private paper currency was largely a failure, the Swedish parliament eventually took over the issue of paper money in the country. By 1745, its paper money was inconvertible to specie, but acceptance was mandated by the government. [20] This fiat currency depreciated so rapidly that by 1776 it returned to a silver standard. Fiat money also has other roots in 17th-century Europe, having been introduced by the Bank of Amsterdam in 1683. [21]

New France 1685–1770

In 17th century New France, now part of Canada, the universally accepted medium of exchange was the beaver pelt. As the colony expanded, coins from France came to be widely used, but there was usually a shortage of French coins. In 1685, the colonial authorities in New France found themselves seriously short of money. A military expedition against the Iroquois had gone badly and tax revenues were down, reducing government money reserves. Typically, when short of funds, the government would simply delay paying merchants for purchases, but it was not safe to delay payment to soldiers due to the risk of mutiny.

Jacques de Meulles, the Intendant of Finance, came up with an ingenious ad-hoc solution – the temporary issuance of paper money to pay the soldiers, in the form of playing cards. He confiscated all the playing cards in the colony, cut them up into pieces, wrote denominations on the pieces, signed them, and issued them to the soldiers as pay in lieu of gold and silver. Because of the chronic shortages of money of all types in the colonies, these cards were readily accepted by merchants and the public and circulated freely at face value. It was intended to be purely a temporary expedient, and it was not until years later that its role as a medium of exchange was recognized. The first issue of playing card money occurred in June 1685 and was redeemed three months later. However, the shortages of coinage reoccurred and more issues of card money were made in subsequent years. Because of their wide acceptance as money and the general shortage of money in the colony, many of the playing cards were not redeemed but continued to circulate, acting as a useful substitute for scarce gold and silver coins from France. Eventually, the Governor of New France acknowledged their useful role as a circulating medium of exchange. [22]

As the finances of the French government deteriorated because of European wars, it reduced its financial support for its colonies, so the colonial authorities in Canada relied more and more on card money. By 1757, the government had discontinued all payments in coin and payments were made in paper instead. In an application of Gresham’s Law – bad money drives out good – people hoarded gold and silver, and used paper money instead. The costs of the war with the British led to rapid inflation in New France. Following the British conquest in 1760, the paper money became almost worthless, but business did not come to a halt because gold and silver that had been hoarded came back into circulation. Under the Treaty of Paris (1763), the French government agreed to convert the outstanding card money into debentures, but with the French government essentially bankrupt, these bonds fell into default and by 1771 they were worthless.

The Royal Canadian Mint still issues Playing Card Money in commemoration of its history, but now in 92.5% silver form with gold plate on the edge. It therefore has an intrinsic value which considerably exceeds its fiat value. [23] The Bank of Canada and Canadian economists often use this early form of paper currency to illustrate the true nature of money for Canadians. [22]

18th and 19th century

Adoption of 'Gold Standard' (Paper currency convertible into gold) [24]
CountryYear
United Kingdom 1821
Germany1871
Sweden1873
United States (de facto)1873
France 1874
Belgium1874
Italy1874
Switzerland1874
Netherlands1875
Austria-Hungary 1892
Japan 1897
Russia1898
United States (de jure)1900

An early form of fiat currency in the American Colonies were "bills of credit." [25] 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. [25] Since the notes were denominated in the local unit of account, they were circulated from person to person in non-tax transactions. These types of notes were issued particularly in Pennsylvania, Virginia and Massachusetts. Such money was sold at a discount of silver, which the government would then spend, and would expire at a fixed point in time later. [25]

Bills of credit have generated some controversy from their inception. Those who have wanted to highlight the dangers of inflation have focused on the colonies where the bills of credit depreciated most dramatically – New England and the Carolinas. [25] Those who have wanted to defend the use of bills of credit in the colonies have focused on the middle colonies, where inflation was practically nonexistent. [25]

Colonial powers consciously introduced fiat currencies backed by taxes, e.g. hut taxes or poll taxes, to mobilise economic resources in their new possessions, at least as a transitional arrangement. The purpose of such taxes was later served by property tax. The repeated cycle of deflationary hard money, followed by inflationary paper money continued through much of the 18th and 19th centuries. Often nations would have dual currencies, with paper trading at some discount to specie-backed money.

Examples include the “Continental” issued by the U.S. Congress before the Constitution; paper versus gold ducats in Napoleonic era Vienna, where paper often traded at 100:1 against gold; the South Sea Bubble, which produced bank notes not backed by sufficient reserves; and the Mississippi Company scheme of John Law.

During the American Civil War, the Federal Government issued United States Notes, a form of paper fiat currency popularly known as 'greenbacks'. Their issue was limited by Congress just slightly over $340 million. During the 1870s, withdrawal of the notes from circulation was opposed by the United States Greenback Party. It was termed as 'fiat money' in an 1878 party convention. [26]

20th century

After World War I, governments and banks generally still promised to convert notes and coins into their underlying nominal commodity (redemption in specie, typically gold) on demand. However, the costs of the war and the required repairs and economic growth based on government borrowing afterward made governments suspend redemption in specie. Some governments were careful of avoiding sovereign default but not wary of the consequences of paying debts by consigning newly printed cash which had no metal-backed standard to their creditors, which led to hyperinflation  – for example the hyperinflation in the Weimar Republic.

From 1944 to 1971, the Bretton Woods agreement fixed the value of 35 United States dollars to one troy ounce of gold. [27] Other currencies were pegged to the U.S. dollar at fixed rates. The U.S. promised to redeem dollars in gold to other central banks. Trade imbalances were corrected by gold reserve exchanges or by loans from the International Monetary Fund.

The Bretton Woods system collapsed in what became known as the Nixon Shock. This was a series of economic measures taken by United States President Richard Nixon in 1971, including unilaterally canceling the direct convertibility of the United States dollar to gold. Since then, a system of national fiat monies has been used globally, with freely floating exchange rates between the major currencies. [28]

Money creation and regulation

A central bank introduces new money into the economy by purchasing financial assets or lending money to financial institutions. Commercial banks then redeploy or repurpose this base money by credit creation through fractional reserve banking, which expands the total supply of broad money (cash plus demand deposits).[ citation needed ]

In modern economies, relatively little of the supply of broad money is in physical currency. For example, in December 2010 in the U.S., of the $8,853.4 billion in broad money supply (M2), only $915.7 billion (about 10%) consisted of physical coins and paper money. [29] The manufacturing of new physical money is usually the responsibility of the central bank, or sometimes, the government's treasury.

The Bank for International Settlements, published a detailed review of payment system developments in the G10 countries in 1985 in the first of a series that has become known as "red books". Currently the red books cover the participating countries on Committee on Payments and Market Infrastructures (CPMI). [30] A red book summary of the value of banknotes and coins in circulation is shown in the table below where the local currency is converted to US dollars using the end of the year rates. [31] The value of this physical currency as a percentage of GDP ranges from a high of 19.4% in Japan to a low of 1.7% in Sweden with the overall average for all countries in the table being 8.9% (7.9% for the US).

Banknotes and coins in circulation (2015-12-31)
CountryBillions of dollarsPer capita
United States$1,425$4,433
Eurozone $1,210$3,571
Japan$857$6,739
India$251$195
Russia$117$799
United Kingdom$103$1,583
Switzerland$76$9,213
Korea$74$1,460
Mexico$72$599
Canada$59$1,641
Brazil$58$282
Australia$55$2,320
Saudi Arabia$53$1,708
Hong Kong SAR$48$6,550
Turkey$36$458
Singapore$27$4,911
Sweden$9$872
South Africa$6$113
Total/Average$4,536$1,558

The most notable currency not included in this table is the Chinese yuan, for which the statistics are listed as "not available".

Inflation

The adoption of fiat currency by many countries, from the 18th century onwards, made much larger variations in the supply of money possible. Since then, huge increases in the supply of paper money have taken place in a number of countries, producing hyperinflations – episodes of extreme inflation rates much higher than those observed in earlier periods of commodity money. The hyperinflation in the Weimar Republic of Germany is a notable example.

Economists generally believe that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. [32] Today, most economists favor a low and steady rate of inflation. [33] Low (as opposed to zero or negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduces the risk that a liquidity trap prevents monetary policy from stabilizing the economy. [34] However, money supply growth does not always cause nominal price increases. Money supply growth may instead lead to stable prices at a time in which they would otherwise be falling. Some economists maintain that under the conditions of a liquidity trap, large monetary injections are like "pushing on a string." [35] [36]

The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control monetary policy through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements. [37]

Loss of backing

A fiat-money currency greatly loses its value should the issuing government or central bank either lose the ability to, or refuse to, further guarantee its value. The usual consequence is hyperinflation. Some examples where this has occurred are the Zimbabwean dollar, China in 1945 and the mark in the Weimar Republic in 1923.

But this need not necessarily occur; for example, the so-called Swiss dinar continued to retain value in Kurdish Iraq even after its legal tender status was withdrawn by the Iraqi central government which issued the notes. [38] [39]

See also

Notes

  1. See Monetary economics for further discussion.

Related Research Articles

Hyperinflation very high and rapidly accelerating inflation

In economics, hyperinflation is very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This causes people to minimize their holdings in that currency as they usually switch to more stable foreign currencies, often the US Dollar. Prices typically remain stable in terms of other relatively stable currencies.

Gold standard monetary system in which the standard economic unit of account is based on a fixed quantity of gold

A gold standard is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold. Three types can be distinguished: specie, bullion, and exchange.

Inflation increase in the general price level of goods and services in an economy over a period of time

In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. The measure of inflation is the inflation rate, the annualized percentage change in a general price index, usually the consumer price index, over time. The opposite of inflation is deflation.

Commodity money Money with value derived from composition from a commodity (such as silver or gold coins)

Commodity money is money whose value comes from a commodity of which it is made. Commodity money consists of objects that have value in themselves as well as value in their use as money.

Representative money any type of money that has face value greater than its value as material substance

Representative money is any medium of exchange that represents something of value, but has little or no value of its own. However, unlike some forms of fiat money, to be a genuine representative money, there must always be something valuable supporting the face value represented.

Seigniorage, also spelled seignorage or seigneurage, is the difference between the value of money and the cost to produce and distribute it. The term can be applied in two ways:

Convertibility is the quality that allows money or other financial instruments to be converted into other liquid stores of value. Convertibility is an important factor in international trade, where instruments valued in different currencies must be exchanged.

The history of the United States Dollar refers to more than 240 years since the Continental Congress of the United States authorized the issuance of Continental Currency in 1775. On April 2, 1792, the United States Congress created the United States dollar as the country's standard unit of money. The term dollar had already been in common usage since the colonial period when it referred to eight-real coin used by the Spanish throughout New Spain.

Hungarian pengő former currency of Hungary, used 1927–1946

The pengő was the currency of Hungary between 1 January 1927, when it replaced the korona, and 31 July 1946, when it was replaced by the forint. The pengő was subdivided into 100 fillér. Although the introduction of the pengő was part of a post-World War I stabilisation program, the currency survived for only 20 years and experienced serious hyperinflation. It was the most serious case of hyperinflation ever recorded.

The history of money concerns the development of social systems that provide at least one of the functions of money. Such systems can be understood as means of trading wealth indirectly; not directly as with barter. Money is a mechanism that facilitates this process.

Early American currency paper money issued by the United States during the American Revolution

Early American currency went through several stages of development during the colonial and post-Revolutionary history of the United States. Because few coins were minted in the thirteen colonies that became the United States, foreign coins like the Spanish dollar were widely circulated. Colonial governments sometimes issued paper money to facilitate economic activities. The British Parliament passed Currency Acts in 1751, 1764, and 1773 that regulated colonial paper money.

History of the Canadian dollar History of currency in Canada

Canada has an extensive history with regard to its currencies. Prior to European contact, indigenous peoples in Canada used items such as wampum and furs for trading purposes, which continued when trade with Europeans began.

Shinplaster

Shinplaster was a common name for paper money of low denomination, less than one dollar, circulating widely in the economies of the 19th century where there was a shortage of circulating coinage.

Money Object or record accepted as payment

Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The main functions of money are distinguished as: a medium of exchange, a unit of account, a store of value and sometimes, a standard of deferred payment. Any item or verifiable record that fulfils these functions can be considered as money.

Metallism is the economic principle that the value of money derives from the purchasing power of the commodity upon which it is based. The currency in a metallist monetary system may be made from the commodity itself or use tokens such as national banknotes redeemable in that commodity. The term was coined by Georg Friedrich Knapp to describe monetary systems using coin minted in silver, gold or other metals.

Hyperinflation in the Weimar Republic occurance of hyperinflation in early 20th century Germany

Hyperinflation affected the German Papiermark, the currency of the Weimar Republic, between 1921 and 1923. It caused considerable internal political instability in the country, the occupation of the Ruhr by France and Belgium as well as misery for the general populace.

In macroeconomics, chartalism is a theory of money which argues that money originated with states' attempts to direct economic activity rather than as a spontaneous solution to the problems with barter or as a means with which to tokenize debt, and that fiat currency has value in exchange because of sovereign power to levy taxes on economic activity payable in the currency they issue.

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