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Understanding Fiat vs. Representative Money
Understanding Fiat vs. Representative Money
Understanding Fiat vs. Representative Money
Representative Money
ECONOMY ECONOMICS
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KEY TAKEAWAYS
Fiat money is both physical money and legal tender and is backed by a nation's
government.
Representative money is backed by a physical commodity such as precious metals or
instruments like checks and credit cards.
Before 1971, the world's currencies were representative and backed by gold.
Fiat money is subject to the effects of inflation, during which time it may lose its value
in the global markets.
Fiat Money
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Fiat Money
Fiat money is a form of currency that is declared legal tender. This includes money in circulation
such as paper money or coins. Fiat money is backed by a country's government instead of a
physical commodity or financial instrument. This means most coin and paper currencies that
are used throughout the world are fiat money. This includes the U.S. dollar, the British pound,
the Indian rupee, and the euro.
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The value of fiat money is not determined by the material with which it is made. That means the
metals used to mint coins and the paper used for bills are not valuable themselves. Rather, the
value of the money is determined by the government. It retains its value through government
stability and that of the nation's economy.
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Fiat money became the norm after U.S. President Richard Nixon decided to abandon the gold
standard in 1971. By doing so, he announced that the dollar was no longer convertible into gold.
Because it can no longer be converted into gold and is not directly tied to the amount of gold a
government stores, fiat money is at risk from inflation. This means it can lose its value in the
face of economic uncertainty. If the government prints too much money, the value of its
currency drops.
That was the case in Zimbabwe. Hyperinflation—extremely fast and out-of-control inflation—
caused the currency to lose its value. The government began printing banknotes with higher
values in order to keep up with inflation. The country's central bank had to stop printing money,
causing the Zimbabwe dollar to officially lose value in the foreign currency market. The country
eventually turned to the U.S. dollar as its base currency.
R t ti M
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Representative Money
Representative money has a long history. In the 17th and early 18th centuries, furs and
commodities like corn were used in transactions. This was followed by precious metals like gold
and silver.
Up until 1970, the world followed the gold standard, where a person was able to exchange the
money they held directly for gold. A country that followed the gold standard set a fixed price for
gold, buying and selling gold at that price. That fixed price was used to determine the value of
the currency. So if Britain set the price of gold at £500 an ounce, the value of the dollar would be
1/500th of an ounce of gold.
Important: The major appeal for representative money was that it was not
influenced by inflation—governments were only able to print enough money for the
amount of gold they held in their vaults.
Key Differences
While fiat money doesn't have intrinsic value—that being through an objective calculation—its
value is set by the government that issues the currency. Most modern currencies around the
world are forms of fiat money. Fiat money can be used to buy goods and services since both
parties involved in a transaction agree on the currency's value.
Representative money, on the other hand, is valued based on the instrument backing it,
whether that's a commodity, asset, or another financial instrument such as a check. A single
dollar may, for instance, be worth a specific amount of gold. Most currencies are no longer
backed by commodities. But there are still other forms of representative money, such as checks,
money orders, and bank drafts. They can be exchanged for the value listed on the instrument.
Special Considerations
As mentioned above, the United States severed its ties with the gold standard in 1971, turning
its currency into fiat money. That led all national currencies to be valued against the U.S. dollar.
Instead of using gold as the power behind the money, the government is the strength and the
reason fiat money has value The money has value because the government says it does In
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reason fiat money has value. The money has value because the government says it does. In
turn, people want to have fiat money.
If the government falls on hard times or if people everywhere suddenly did not want a form of
currency such as the U.S. dollar, it would lose all of its value because there is no physical gold
behind it.
But many governments end up printing too much paper money, which leads to inflation. A
dollar is no longer worth a dollar in gold. When this happens, the money becomes fiat money.
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Related Terms
Fiat Money
Fiat money is a government-issued currency that is not backed by a physical commodity, such as gold or
silver. more
Gold Standard
The gold standard is a system in which a country's government allows its currency to be freely converted
into fixed amounts of gold. more
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Chartalism Definition
Chartalism is a non-mainstream theory that emphasizes the impact of government policies and activities
on the value of money. more
Debasement
Debasement refers to lowering the value of a currency, particularly of one based on a precious metal, by
adding metal of inferior value. more
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