Fiat currency refers to any currency whose value is not supported by physical assets like gold or silver. Instead, it is backed by the government that issued it and is recognised as legal tender. This means that the US dollar, for instance, does not have any physical commodity backing its value. The confidence the public has in the government and the central bank of the issuing nation supports the value of fiat currency. If a country becomes bankrupt, its fiat currency would lose value significantly.
Currencies used across the world can be classified into two major categories: commodity standard and legal tender. The gold standard is an example of the former, while the US dollar and most modern currencies are examples of the latter. However, there is a debate over which type of currency is better.
Fiat currency is produced or printed to deal with inflation, and this gives a government good control over its economy. For example, the US switched to fiat currency from a gold-backed currency to effectively deal with an economic depression. Paper money is produced when the government signals the need for more cash to strike a balance between supply and demand in the money market, which in turn affects the price of goods. Prices will rise when the supply of cash runs low, but this can be solved by printing more money. However, excessive printing of paper money can lead to its devaluation and render it worthless in the long run, which can harm a nation's economy.
The US dollar is recognised as the most prominent fiat money in global economies since the US cut ties with a gold-backed currency in the 1930s. Gold standard or money backed by physical commodities bases its value on precious metals. The value of a country's currency under the gold standard was tied to the amount of gold held by the central bank. The amount of money a country could print was limited by the amount of gold it had, and commodities like gold and silver were considered to be more stable stores of value due to their limited supply and long-standing recognition as a medium of exchange.
Fiat currency is backed only by the government's promise to pay, giving central banks the power to print as much money as they want. While the gold standard provided stability and limited inflation, the flexibility of fiat currency allows governments to stimulate economic growth by increasing the money supply. However, the value of fiat currency is subject to fluctuations and can be impacted by factors like inflation and changes in interest rates.
The purchasing power of gold (dinar) remains stable over time, and as the price of gold increases, it typically offsets the decrease in the value of fiat currencies in relation to the cost of goods and services. The value of gold remains stable during times of economic uncertainty or geopolitical turmoil as investors tend to turn to it as a safe-haven asset. For a gold currency to run efficiently, the entity managing it should mine, supply, and store gold efficiently, which is an expensive and difficult undertaking. This is one reason why most governments prefer fiat currency.
In conclusion, understanding fiat currency and its relationship to the economy can help individuals make informed decisions regarding investing in currencies. While the debate over which type of currency is better continues, it is important to recognise the role of both commodity standard and legal tender currencies in shaping the global economy.