However, one cannot ignore the fact that commodity money is subject to huge price fluctuation. Whereas, fiat money is a future obligation as it is simply a promise to pay in the future. Payment is never made when it comes to fiat money, instead it is only discharged. But commodity money, on the other hand, completes the transaction.
Under a commodity monetary system, final payment is always made in the form of commodity that is being used as money in the transaction. The commodity is used as a final payment because there is no obligation and receiving the commodity in payment ends all further obligations.
Fiat money is a paper money and it represents nothing but a promise or an obligation. Under a fiat monetary system, final payment never occurs because a transaction is executed with a promise, a representation, or an obligation that something else is owed. Here, monetary unit is a legal fiction.
It is not tangible and does not have any defined unit of measure. On the other hand, the governments maintain control of the money under a fiat monetary system and can change the supply of money whenever they want to suit political considerations. The public at large decides the number of gold coins they need by the quantity of gold that was brought to the mint for coinage and by the number of gold coins that were melted for other usages.
Therefore, it can be said that the value of commodity money is determined by the wisdom and knowledge of all the people who are regulating the supply of money. In case of the fiat monetary system, governmental monetary policy is required to regulate the quantity of fiat money.
Expert opinion is required for the development of this policy in order to achieve the desirable goals. However, the policy is entirely based on the personal value judgment of these experts and once the policy is finalized, government forces are required to implement this policy. It is directly associated with the government debt even if it is directly issued by the government and is interest free.
Whereas, commodity money is an economic currency and its quantity is determined by the needs of the economy as it is associated with the production of real goods and services. With commodity money, the value of commodity money is determined by the production of commodities. Governments may debase coins by adding copper, tin, or other less valuable alloys to coins as they are minted, while still saying they are worth e.
Individuals may also debase gold or silver coins by clipping the edges or filing off shavings from coins, melting those small amounts down, and selling them. This results again in coins in circulation that contain less precious metal than indicated. For convenience and to avoid these price changes, many governments issue fiat currency. Fiat money is a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it.
The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it as is the case for commodity money. Most modern paper currencies are fiat currencies, including the U. Initially, many fiat currencies were backed by a commodity. Backing a fiat currency with a commodity provides more stability and encourages confidence in the financial system.
Anyone could take backed fiat currency to the issuing government and exchange it for a certain amount of the commodity. Eventually, many governments no longer backed fiat currency, and the money increasingly took on a value based on public confidence.
As of , U. Because fiat money is not linked to physical reserves, such as a national stockpile of gold or silver, it risks losing value due to inflation or even becoming worthless in the event of hyperinflation.
If people lose faith in a nation's currency, the money will no longer hold value. That differs from currency backed by gold, for example; it has intrinsic value because of the demand for gold in jewelry and decoration as well as the manufacture of electronic devices, computers, and aerospace vehicles. The African nation of Zimbabwe provided an example of the worst-case scenario in the early s. In response to serious economic problems, the country's central bank began to print money at a staggering pace.
That resulted in hyperinflation, which ran between million and billion percent in At the height of the crisis, one U. Earl J. Harvard University Press, Federal Reserve Bank of St. Accessed Aug. State Department. World Gold Council.
Federal Reserve Bank of Dallas. Accessed August 28, Monetary Policy. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. These choices will be signaled globally to our partners and will not affect browsing data. Fiat money by contrast, has no intrinsic value — it is essentially a promise from a government or central bank that the currency is capable of being exchanged for its value in goods.
Well-known examples of fiat currencies include the pound sterling, the euro and the US dollar. In fact, very few world currencies are true commodity currencies and most are, in one way or another, a form of fiat money. This means that governments can manage the credit supply, liquidity and interest rates more reliably. Since it is not tied to a tangible asset, the value of fiat money is dependent on responsible fiscal policy and regulation by the government.
Irresponsible monetary policy can lead to inflation and even hyperinflation of a fiat currency. Adding to this, there is greater opportunity for bubbles with fiat currency — an economic cycle in which there is a rapid increase in price before an equally rapid decline in price.
The increased prevalence of bubbles is because fiat currencies have a virtually unlimited supply, which means that quantitative easing is an option for governments. While possibly providing stimulus to an economy, quantitative easing can also cause greater inflation rates. This could impact anything from housing prices to national debt levels, which in turn could impact the financial markets.
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