Fiat currency is the money that is declared by the government as having no intrinsic value and is promised to function as legal tender by the government. The fiat money is not backed by reserves. The history of money says that currencies used to be based on the value of certain commodities like gold or silver. But the concept of fiat currency is different and is solely based on faith. In the present world, most of the currencies of the world are fiat money.
There are some risks involved with the fiat money. Since the money is not backed by any physical reserves, the value of money can suffer hyperinflation and become worthless. As the fiat money concept entirely depends on the human faith, if people lose belief on the nation, the fiat money may hold no value at all. The fiat currency is very often related with the concept of paper money since all the legal obligations are actually settled and created by paper documents.
In other words, it can also be said that the fiat currencies are described as those currencies that are not fixed or pegged to a precious metal mass. The inherent value of paper money is believed to be zero.
The concept of fiat currency is believed to arise from the burden of excessive public debt. In the cases when the government is unable repay the debt in some precious metals like gold or silver, the government prefers to remove the physical backing from currency rather than going for defaulting.
The individuals in the economy should be able to make tradeoff decisions between the liquidity of money and having a good service. Some time the government may fail in backing or maintaining the supply of money. In that case the economists would like to take some decisions causing the risk that the money value will change abruptly. Then a heavy economic distortion occurs resulting in a depression. In such a case the concept of fiat currency can be useful to stabilize the economy and money value of a particular currency.
Last Updated on : 1st July 2013