You need to know this – Fiat Currency

Before I tell you, what fiat currency is we need to know the difference between money and currency and how it affects us. In simple words money stores value over a long period of time and the simplest example are gold and silver. There is a reason behind why people always assume that investing in gold and silver are safe and that is because they hold their value over a long period of time. There is a finite amount of this precious metals on our earth and this very fact makes these types of money a useful tool for trade in the early days when humans started trading.

Currency on the other hand is nothing but the physical representation of value and in our world, is simply a piece of paper with different characteristics. When we hold a note of any denomination it is just a piece of paper which the government of that particular country has promised holds the value of the denomination mentioned. Currency is affected by manmade events, inflation etc.

Now the question that comes is based on what does this value come? How is this value determined?

The answer is trust. Yes, our whole economy and the financial structure runs on trust and the system is controlled by a firm grip of the central banker. The central bank is the all-powerful in the world of economics. Its decisions can have widespread effects on the society. But that is going to be a topic for some other blog.

But how did we reach to this mess? Why should currency be based on trust and not on something tangible like GOLD. This was actually the case. Currency was backed by GOLD. It was called the Gold Standard. It’s a monetary system that directly links a currency’s value to that of gold. A country on the gold standard cannot increase the amount of money in circulation without also increasing its gold reserves. Because the global gold supply grows only slowly, being on the gold standard would theoretically hold government overspending and inflation in check. But in 1971 President Richard Nixon completely abandoned the Gold standard in the United States of America. But the process of removing from the Gold Standard was started way back in 1933 by FDR for dollar and in 1931 for the pound sterling.

But why so?

To help combat the Great Depression. Faced with mounting unemployment and spiralling deflation in the early 1930s, the U.S. government found it could do little to stimulate the economy. To deter people from cashing in deposits and depleting the gold supply, the U.S. and other governments had to keep interest rates high, but that made it too expensive for people and businesses to borrow. So, in 1933, President Franklin D. Roosevelt cut the dollar’s ties with gold, allowing the government to pump money into the economy and lower interest rates. The U.S. continued to allow foreign governments to exchange dollars for gold until 1971, when President Richard Nixon abruptly ended the practice to stop dollar-flush foreigners from sapping U.S. gold reserves.

All modern currency is known as Fiat Currency. To define it we can say Fiat money is currency that a government has declared to be legal tender, but it is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of. Because fiat money is not linked to physical reserves, it risks becoming worthless due to hyperinflation. If people lose faith in a nation’s paper currency, like the U.S. dollar bill, the money will no longer hold any value.

So basically, next time when you are paying someone with cash remember that you are only giving trust and nothing else.

Sources:  http://mentalfloss.com/article/12715/why-did-us-abandon-gold-standard

Sources: http://www.history.com/this-day-in-history/fdr-takes-united-states-off-gold-standard

Sources: http://www.investopedia.com/terms/f/fiatmoney.asp

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