An Overview of Fiat and Representative Money
Physical money including both coins and paper money is known as fiat money. While a form of currency that represents the intent to pay, such as a cheque is known as representative money. Both money is supported by something. They would be completely worthless without any support. Government backs fiat money, while different assets or financial instruments back representative money. For example, the money in a bank account backs the personal check.
What Is Fiat Money?
A form of currency that is declared legal tender is known as fiat money, paper money, or coins are included in it. country’s government supports Fiat money instead of a financial instrument or any physical commodity. This means that most of the coins and paper currencies used all over the world are fiat money.
The worth of fiat money is not decided by the type of material with which it is made. It means that the metals or the papers used to mint coins or paper bills are not worthy in themselves. Instead, the value of the money is set by the government. The value set remains stable till the government is stable and also the economy of the nation.
After U.S. President Richard Nixon decided to abandon the gold standard in 1971, fiat money became a standard. After that, he proclaimed that the dollar can no longer be convertible into gold. Fiat money is at risk from inflation as fiat money can not be converted into gold and is not directly attached to the sum of gold the government stores. This shows that in the face of economic uncertainty, it can lose its value. The value of its currency drops If the government prints too much money.
To keep up with inflation, the government started printing banknotes with higher values.
This is what happened in Zimbabwe. The currency loses its value due to Hyperinflation— extremely fast and out-of-control inflation. To keep up with inflation, the government started printing banknotes with higher values. Then the country’s central bank had to stop printing money, forcing the Zimbabwe dollar to lose value officially in the foreign currency market. Then the country, at last, had to look up to the U.S. dollar as its base currency.
What Is Representative Money?
Government-produced money backed by a physical commodity such as precious metals is known as Representative money. Some other forms of representative money are financial instruments like checks and credit cards.
In place of traditional money, these forms of payment are used today, with the intention of paying at a later date.
Representative money is having a long history. Furs and commodities such as corn were used in transactions, in the 17th and early 18th centuries, followed by precious metals like gold and silver.
Till 1970, everyone followed the gold standard, where the money people held was directly exchanged for gold. A country that adopted the gold standard fixed a particular price for gold, purchasing and vending the gold at the same price. And that price was a measure to decide the worth of the currency.
The main benefit of representative money was that it was not affected by inflation as the amount of gold the governments held in their vaults, only that much of money was printed.
Key Differences Between Fiat and Representative Money
The value of fiat money is set by the currency issuing authority ie the government. It doesn’t have its own inherent value. Most of today’s currencies all over the world are embodiments of fiat money. As the parties involved in a transaction agree on the currency’s value fiat money can be used to buy goods and services.
On the other hand, whether it is a commodity, asset, or another financial instrument such as a check, or representative money, is valued based on the instrument backing it.
Most of the currencies are no more backed by commodities. Still, some other embodiments of representative money, such as checks, money orders, and bank drafts can be used to exchange for the value listed on the instrument.
Special Considerations
As stated, the U.S. in 1971, cut off its ties with the gold standard and turned its currency into fiat money. Then all the national currencies were valued against the U.S. dollar. The government is the strength and the reason fiat money has value, the gold has no power in it. Money acquires value as the government says so. And people in turn want to have fiat money.
Fiat money loses its value if people everywhere suddenly did not want a form of currency or the government falls on hard times as there is no physical gold backing it.
But because printing too much paper money, by many governments leads to inflation. A currency is no longer worth in gold. And the money becomes fiat money when this happens.
So, fiat money is backed by a nation’s government and is both physical money and legal tender. Whereas, representative money is supported by instruments such as checks and credit cards or physical commodities such as precious metals.
