Fiat Money Definition – What is a Fiduciary Currency?

Asset classes

Fiat Money & Fiduciary Currency

Fiat currency and fiduciary currency are among the different types of money. If you want to know all about these two major types of money, you have hit the right platform. 

Understanding fiat money and fiduciary money are important to understand how modern economies work. Therefore, we decided to help you know all about these two types of money. Our today’s detailed guide will help you understand what money is, its different types, and detailed information about fiat and fiduciary currencies. 

What is money?

According to economists, money is any medium of exchange for goods and services. In other words, money performs three major functions – medium of exchange, unit of account and store of value. That’s the reason that we don’t have just one type of money. Rather we have seen four different types of money throughout human history. 

  • Commodity money – The oldest type and perhaps the simplest type of money is commodity money. It means using commodities as a medium of exchange. In the past, commodity money was used in commerce. People used to accept goods or services in exchange for other goods and services. The most important thing to note here is that the value of commodity money depends on the intrinsic value of the commodity itself. That means the commodity itself serves as money. The most common commodity money examples include gold, silver, spices, etc.
  • Fiat money – Fiat money means the notes and coins issued by a government and getting their value from government orders. We shall discuss fiat money in detail after a short while.
  • Fiduciary money – Fiduciary money isn’t issued by a government. Rather its value depends on the instrument backing it. For example, cheques are fiduciary money.
  • Commercial bank money – Commercial bank money refers to debts that commercial banks generate that people can use as a medium of exchange to buy goods or services. 

So, there are four main types of money. Let’s get back to our main topics and see what fiat money and fiduciary money are in detail. 

What is fiat money?

In simplest terms, fiat currency is notes and coins issued by a government. They don’t have their own intrinsic value. Rather they gain their value from the government that issues them. Moreover, fiat currency isn’t backed by any scarce physical commodity like gold. All the major currencies in the world right now are fiat currencies such as the US dollar, the British Pound, etc.

History of fiat money

The Yuan, Tang, Song, and Ming dynasties in China are generally credited with the introduction of fiat money. According to history books, the demand for metallic currencies rose significantly high. However, the supply of precious metals was way less than the demand. As a result, people started to use and accept paper drafts. Thus, the shortage of metallic coins forced people to accept notes.

Later on, the shortage of copper coins during the Song dynasty forced people to issue private notes backed by a monetary reserve. This was the first-ever legal tender that became the only legal tender during the Yuan dynasty. The fiat currency idea was further refined during the Ming dynasty when the Ministry of Finance became the only issuer of notes.

The West adopted paper money back in the 18th century when American colonies and France introduced bills of credit. However, bills of credit soon became controversial because too many bills were issued. As a result, they started to lose their value. It forced governments to accept the conversion of fiat currencies into precision metals such as gold. Later on, the Bretton Woods Agreement gave a new equation wherein one troy ounce of gold was equal to 35 US dollars. 

However, the revolutionary American president, Richard Nixon, introduced numerous economic measures. One of those measures was to cancel the direct conversion of fiat currencies into gold because of declining gold reserves. Since then, almost all countries in the world adopted fiat currency and the exchange of one currency into the other became possible.

Fiat currency explained

Fiat is a Latin word that means “let it be done.” That means fiat currencies don’t have any intrinsic value. In other words, any note or coin that we use for purchases doesn’t have its own value. The issuing government maintains its value. The government does it by declaring fiat money to be legal tender. That means, all the citizens of that state, businesses, and everyone in between are required to accept fiat currency in exchange for goods or services. If they don’t do so, the government fines them or even puts them in prison. 

However, it is important to note that fiat currency value also depends on supply and demand just like commodity money. It will drop its value in case of excessive supply. Fiat currency is also prone to becoming totally worthless if inflation surges. A recent example is Zimbabwe where the government issued too much currency. As a result of it, inflation surged and Zimbabwean currency lost its value.

Furthermore, the value of fiat currency also depends heavily on people’s faith. That means, if people lose faith in the currency issued and backed by their government, its value begins to deteriorate. However, it cannot happen to a currency backed by commodities like gold. Currency backed by any commodity maintains its value because it has its intrinsic value because of the demand for the commodity backing that currency. 

What is fiduciary currency?

Legal tender?

Fiduciary money or currency isn’t issued by any government. Its value depends on the financial instrument backing it. For example, dollars in a bank account of a trader provides value to the cheques he issues. Fiduciary money is also known as representative money.

Furthermore, fiduciary money isn’t legal tender. That means we are not required by the government to accept fiduciary money in any transaction. It depends on the mutual consent of both parties involved in a transaction. 

Pros & Cons?

Fiduciary money has brought a lot of advantages for people all across the globe. Although it is easy to buy goods or services with fiat currencies, what if there are large transactions. Imagine buying a really expensive item that requires you to pay a lot of cash. You will be carrying bags full of cash. Conversely, if you sign a cheque and pay in exchange for the item, how convenient it would be. 

However, there are also disadvantages to fiduciary money. It needs clearance. For example, if you pay by cheque, it needs to be cleared by the issuing bank. That said, it takes longer than the fiat money that settles a transaction immediately. The bank makes sure we have enough money deposited in the account to accept the cheque or it will bounce. Similarly, debit cards also require us to have enough amounts in our accounts. However, debit cards are a faster medium of paying as electronic forms take only seconds to settle a transaction. 

Credit cards are also an example of fiduciary money. However, they work differently than cheques and debit cards. You don’t need to have money in your account to pay for a transaction. Contrarily, credit cards work on the principle of obligation to pay in the future. In fact, you borrow from the bank when using a credit card. The bank allows you to do so up to a certain limit. It also requires you to pay the borrowed amount within the due date. Credit cards are more profitable for banks as they charge interest on the borrowed amount. 

What are the differences between fiat currency and fiduciary currency? 

There are key differences between fiat currency and fiduciary currency. Firstly, fiat money is the currency issued by a government while fiduciary money isn’t issued by any government. Secondly, people and all firms in a country are required to accept fiat currency in exchange for goods or services. Contrarily, there is no such obligation when using fiduciary money as it depends on the mutual consent of the parties involved. 

Thirdly, fiat currency value is maintained by a government while the fiduciary currency is backed by a financial instrument. Fourthly, fiat currencies settle a transaction immediately whereas fiduciary currency takes time, especially cheques. Finally, fiat currencies aren’t as convenient to carry as fiduciary money because carrying a cheque of 1 million is easier than carrying a bag full of cash. 

Russell Crane

Russell Crane

Russell is an Algorithmic & Technical Analyst Trader @ PatternsWizard.
His passion is to share his knowledge about TA, patterns & more. Why hope for your trading to work when you can precisely know the performance stat of every pattern?

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