Fiat Currencies

Overview

Fiat money is money produced by a government or a central bank whose value arises solely from the fact that the authorities have declared it to be legal tender and from the public's belief that it will be accepted whenever goods and services are purchased or when debts are paid; unlike earlier types of money, fiat money is not supported by a physical commodity, the pound in a bank account, the dollar in an American wallet, and the euro used in the eurozone are all examples of fiat currencies, since their value is based on general confidence and on legal decree rather than on a promise to be exchanged for a specific weight of metal.

This setup is a more recent thing; the United Kingdom abandoned the gold standard in 1931, and the United States cut the last tie between the dollar and gold in 1971, at that time Congress ending convertibility, a move which is frequently referred to as the "Nixon Shock". 

Ever since then, all of the major global currencies, sterling, the dollar, the euro, and the yen, have been fiat money, their value being based on institutional credibility, not on a stock of gold. 

How value is determined

Since fiat money has no intrinsic value, its value comes entirely from market forces and policy choices. The key elements are supply and demand: when more money is printed than there is a matching quantity of goods and services in an economy, each unit buys less, and this is one of the principal reasons for inflation. 

Interest rates also play a role; higher rates tend to draw in foreign capital in order to obtain higher returns, which in turn increases demand and the exchange rate, whereas lower rates generally have the opposite effect. 

People's inflation expectations also matter, since currencies expected to lose purchasing power quickly are not very attractive to hold. Moreover, central bank credibility underpins the other factors; markets consider not only what the central bank has done in the past but also what they expect it to do in the future

Central banks

Central banks protect fiat currency and have two primary tools: the power to control the money supply and a base interest rate that affects mortgages, savings rates, and business loans throughout the economy. 

In the United Kingdom, this responsibility lies with the Bank of England, a bank which was established in 1694 and has had a Monetary Policy Committee in charge of setting interest rates since 1997; the committee meets approximately every six weeks with the aim of keeping inflation at the government's 2 per cent target, the Bank Rate having been increased to 3.75 per cent following the MPC's meeting in July 2026. 

Other major monetary authorities, such as the US Federal Reserve, the European Central Bank and the Bank of Japan, adopt the same kind of system. The central bank should be free from day-to-day political interference if the public is to retain confidence in the fiat money system. 

Functions of money

Money has three main functions: a medium of exchange, a unit of account, and a store of value. The third is the most often criticised, since central banks can create fiat money at will, a practice that became much more apparent during quantitative easing after the 2008 financial crisis and again during the pandemic. 

It is argued that this makes fiat money susceptible to depreciation over time through inflation, and it is precisely this concern that has given rise to an interest in alternative stores of value that are outside the control of the government; gold has always had this role, and more recently cryptocurrency, with Bitcoin leading the way, has appeared as a new and much more volatile alternative, a topic which is discussed in the article that follows. 

Risks 

Fiat money is by no means free from risk since its greatest weakness is inflation; its purchasing power may vanish if a central bank is not able to control the quantity of money in circulation or if a government prints money in order to finance its spending, as did the case in Weimar Germany in the past, in Zimbabwe in the late 2000s, and more recently in Venezuela and Argentina. 

Currency crises may also arise when confidence in a government's financial management disappears, leading to sharp depreciation, as occurred briefly in the UK markets during the September 2022 mini-budget, when the pound dropped sharply against the dollar. Since the value of a fiat currency ultimately depends on trust in an institution, it is very difficult to restore that trust once it is lost.