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What is fiat currency?

September 16, 2022

8 min

What is fiat currency?
Beginner

The meaning of currency has evolved over time. There are different types of currencies, and fiduciary (or fiat) currency is in a sense the most modern one. What is a fiat currency? The Euro is an example of one: it is issued by a central bank and controlled by a government. But how is new money created and why is it so important in our daily lives?

Currency: definition and meaning

Before we find out what a fiat currency is specifically, let’s define the term “currency” in a more general sense. The history of money teaches us that, to be successful, a currency must fulfil three functions:

  • Medium of exchange: currencies are used for the purchase of goods and services provided by a seller. They acknowledge the value of the currency by accepting it as part of the exchange;
  • Unit of account: currencies are the ‘unit of price measurement‘, i.e. a criterion for universally quantifying the value of goods and services, so that they can be compared according to common standards;
  • Reserve of Value: currencies allow you to conserve purchasing power so that you can use it on future occasions. In short, it enables savings.
The nature and history of fiat currencies

In order to achieve these goals, human civilisation has created four types of currency that have shaped our societies and economies:

  1. Commodity coins – a medium of exchange endowed with intrinsic value regardless of its function as a means of payment, such as precious metals (gold and silver). Later, these ‘intermediate’ goods in buying and selling, chosen for their non-perishability, were used to mint coins. The value of the coins would be guaranteed by the nature of their composition;
  2. Representative currency – coins and banknotes that are exchangeable for certain amounts of gold or silver, but without intrinsic value. They represent an underlying asset and give the holder the right to convert them into the latter;
  3. Fiduciary currency – also called legal tender or fiat money. It is a payment instrument whose value is neither intrinsic nor dependent on precious metal reserves. It is based on trust in the institution that issues it, such as a central bank. Its value is essentially ‘legal‘ because it is recognised by the state and the participants in the economic system;
  4. Electronic/digital currency – currencies issued by centralised entities, just like trust currencies, but exchanged through different types of networks, such as the internet. It is money contained in current accounts and accessible through credit cards, so not to be confused with cryptocurrencies.

The meaning of currency as well as the relevance of its various types have evolved over millennia of history. Today’s centre stage is clearly occupied by fiat currency. Here is our explanation of what it is:

Fiat currencies: ECB and inflation

By definition, a fiat currency is legal tender. This means that a government chooses an official currency for the state backed by a central bank and a dense network of commercial banks. It must be accepted by law as a means of payment within its territory.

If you know what ‘fiat‘ means, it will be easier for you to understand what a fiat currency is. The term comes from Latin and can be translated as ‘let it be done‘. In a nutshell, it indicates an order given by the government; that is why fiat currency is also called fiduciary (trust based) money. The central bank and the government decide that a certain currency is valid and must be adopted by everyone (thus making it ‘legal tender’). As long as all citizens respect these authoritarian decisions, that currency will retain its value.

There are about 180 fiat currencies in the global market, such as the euro, dollar and pound sterling. The countervalue of one currency against another is called the exchange rate, the criterion behind forex trading.

Exchange rate

The ratio by which one currency can be exchanged for another. In other words, the number of coins that can be bought with one unit of a different currency. Usually, exchange rates are calculated with the local fiat currency, e.g. the Euro, as a reference. The most common term of comparison is the dollar, which is considered the world’s store of value (or reserve currency). The EUR-USD pair dominates by volume for daily transactions.

The value of each of these fiat currencies, or rather their purchasing power, is influenced by several factors. In the case of the Euro, it is first and foremost the European Central Bank (ECB) that manages its issuance and circulation, thus injecting liquidity into national economies.

Moreover, the ECB has to monitor inflation: since the creation of fiat currencies is not subject to any store of value, an excessive production of money could erode the purchasing power of the euro. The ECB’s task, therefore, is extremely important: managing money supply judiciously is essential to mitigate inflation.

Inflation

An increase in the prices of goods and services that leads to a decrease in the purchasing power of a currency. This is sometimes due to the excessive availability of fiat currencies in national economies. It may be a consequence of ECB monetary policies: injecting liquidity into monetary systems in order to facilitate trade threatens the scarcity needed for currencies to maintain their price.

Let’s take a closer look at the role of the ECB and commercial banks in the fiat currency monetary system (Euro). How does the issuance of money work?

How is fiat currency issued?

The European Central Bank (ECB) can be defined as the ‘bank of banks’. Its services are reserved for National Central Banks (NCBs), such as the Bank of Italy. Each EU member state has a national bank.

The ECB and the individual NCBs are the only banks that physically issue banknotes and coins. However, only NCBs actually put money into circulation through a system of Commercial Banks. Metallic and paper money is, indeed, referred to as ‘circulating’, but we know that physical fiat money constitutes less than 10% of the world’s money (6600 billion dollars in total, according to some estimates).

Bank deposits are indeed the most widespread form of money. However, if physical currencies are produced by central banks, who creates the digital currencies of bank deposits?

Commercial banks: deposits and loans

Bank deposits are aggregated in our personal accounts and constitute receipts as electronic balances. Commercial banks handle our credit, delegated by the central banks to service companies and private citizens.

Deposits are the basis of the so-called monetary (or deposit) multiplier, a process by which commercial banks lend money and simultaneously create new digital currencies. The lent money is a debt that the borrower takes with the bank. It does not correspond to real circulating money: it is generated ‘out of thin air’ for the occasion. Despite its free origin, when the borrower repays the loan to the bank (with interest) it will return to balance sheet parity. By doing so, the amount of money generated by the bank will be compensated: the returned capital will replace‘ the previously created coins.

Commercial banks, however, need central banks to feed the money multiplier. In turn, they borrow from the ECB, via NCBs. This is a critical step, because the huge amounts of money granted by the ECB could ‘break’ the equilibrium for currency scarcity, which is the basis of inflation.

Central banks and ‘good’ inflation

A positive inflation rate is physiological in a debt-based economy, but it must allow for relative price stability. In fact, the ECB has defined a 2% tolerance threshold for inflation. Achieving this is complex, given the infinite number of economic actors involved. The ECB does have a number of instruments to manage circulating money and deposits. Mainly, this involves the direct adjustment of interest rates and other measures created ad hoc for the specific situation.

The ECB’s monetary policies are of utmost importance for the welfare of Europe’s citizens, especially in the aftermath of the perfect storm caused by the Covid health emergency, the war in Ukraine and the energy crisis. Current times of unprecedented crisis that give a practical definition to the concept of fiduciary money.

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