Fiat Currency - Explained for Dummies

What is fiat currency?

The word ‘fiat’ is a loanword from Latin, meaning ‘let it be done’. The Oxford Advanced Learner’s Dictionary defines fiat as: ‘An official order given by somebody in authority.’ It was in this regard that the term fiat currency, or fiat money, was coined because it refers to any currency that is declared legal tender by the government of a country. The value of a fiat currency is backed by the government that issued it. Proof of this backing can be seen on the banknotes of a country. For example, on U.S dollar notes you will find the following promise: ‘This note is legal tender for all debts, public and private.’ Furthermore, the seal of the Federal Reserve Bank appears on the notes, as well as the signatures of the Secretary of the Treasury and the Treasurer of the United States. South African banknotes in use until 1992, carried the following promise by the Governor of the South African Reserve Bank on behalf of the South African government: ‘I promise to pay the bearer on demand at Pretoria’, followed by the value of the specific banknote, and signed by the governor. Although the banknotes nowadays only carry the signature of the governor, it is still proof that the government backs the South African currency as a legal tender. Fiat money is the opposite of commodity money, also referred to as commodity backed money or representative money. Commodity money is money whose value is based on a valuable commodity, such as gold. Put differently, representative money is a medium of exchange (such as notes or coins) that represents something with intrinsic value. It has no value of its own, but it represents a claim on a commodity, for example, gold, that can be redeemed.  

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Extracts from the history of fiat money

Throughout history, paper money had acted as promises to pay the bearer a certain amount of precious metal, usually gold or silver. Fiat money was first used in China during the Tang dynasty (618 AD - 907 AD). However, the practice only became official government policy during the Song dynasty (960 AD - 1279 AD). The West started to use paper money as a medium of exchange in the 18th century. The assignat, a paper bill issued in France from 1789 to 1796, during the French Revolution, serves as an example. During the American Civil War (1861 - 1865) the federal government started to issue a type of fiat currency, called ‘greenbacks’, to preserve the value of its precious metals. Germany issued paper marks in the early 1920s. In July 1944, a conference was held in Bretton Woods, New Hampshire in the U.S.A., during which the Bretton Woods Agreement was finalised. It included, inter alia, an agreement that the currencies of the 43 other countries attending, were to be tied to the value of the U.S dollar and that gold would be the basis for the U.S dollar. The value of one troy ounce of gold was tied to 35 U.S dollars. The Bretton Woods Agreement effectively came to an end in 1971 when the U.S.A introduced a law that cancelled the conversion of the U.S dollar into gold. This had the effect that since the early 1970s, most countries have adopted fiat monies that can be exchanged for other foreign currencies.  

Features of fiat currency (fiat money)

In addition to the feature that it is declared a legal tender and backed by a country’s government, fiat money has the following features:

• Fiat currency lacks intrinsic value, implying it has no value in itself. Conversely, a precious metal such as gold has an intrinsic value.
• Fiat money is not backed by a physical commodity, such as gold or silver.
• The value of fiat money is based on, among other things:
• The relationship between supply and demand.
• The stability of the issuing government.
• The state of a country’s economy.
• The faith of the entities and people who use it to trade with.
• Fiat currency enables central banks to exercise greater control over a country’s economy because they can manage the availability of money.

 

Which countries have fiat currency?

As of 2026, almost all the world’s currencies are fiat currencies, including major global currencies such as the U.S. dollar, the British pound, the euro, and the Australian dollar. The South African rand is also a fiat currency.  

How does fiat money works?

Basically, fiat money, also referred to as paper money, is:

• A substitute for the barter system

A barter system is a trading system in which goods and services are exchanged between two or more parties without the use of any type of money. Examples of barter is when bread is exchanged for milk, or when eggs are provided in exchange for honey. Fiat money changes a trading system in which something is exchanged for something else (the barter system), to a system in which fiat money is exchanged for something. This development made trading much easier, enabling individuals, corporations, businesses, governments, etc., to buy things as the need or want occurs.

• A storage for purchasing power

Purchasing power, also called a currency’s buying power, is the value of a currency expressed in terms of the amount of goods or services that a single unit of currency can buy. Due to fiat money’s ability to store purchasing power, people and enterprises are allowed to plan for the future and to participate in specialised economic activities. For example, if you are a dairy farmer, then you can expand your dairy farming by purchasing new equipment, increase your herd, hire employees, and, if necessary, buy additional farmland. Global trading essentially functions by utilizing an interconnected global fiat currency system.  

Some advantages of fiat currency

• One of the most important advantages of fiat money is the relative stability of its value, unlike commodity backed money whose value can be influenced by changing commodity prices that are determined by scarcity or abundance of the given commodity.
• A government can effortlessly manage the relative value of the country’s currency by controlling its supply. By influencing the money supply, a country’s monetary authority is able to influence the economy, managing credit supply, interest rates, and liquidity.
• Flexibility and responsiveness - able to adjust to the needs of growing economies.
• It has outstanding seigniorage, enabling a government to generate profit from the difference between the face value of fiat money, such as banknotes and coins, and their production costs.

 

Some disadvantages of fiat money

• A government with an irresponsible and undisciplined monetary policy can print too much money, referred to as quantitative easing. This can lead to increasing inflation, devaluating the country’s currency. If the quantitative easing gets really out of hand, the currency can almost become worthless through hyperinflation.
• It artificially lowers interest rates, encouraging people to take excessive risks that could cause an escalating solvency crisis.
• Fiat money can cause occasional financial collapse.

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