An introduction to fiat currencies

Welcome to the world of fiat currencies! How does paper hold any value if it's not backed by anything? Well, that's where concepts such as legal tender come in. 

The fiat system, which we still use today, has governments assign value to a currency, declaring it a legal tender. This means that a government decides whether a medium of payment will be recognized for financial transactions, trade settlement, or commerce in a country or jurisdiction.

The legal tender concept is just another manifestation of the perception of value characteristic of money. The key difference here is that with commodity money, there is a tangible resource to which the money supply can be pegged. And with fiat money, the money (or the quantity of money in circulation) is a much more discretionary subject to central banks' policies. Therefore, the margin for human error (involuntary or voluntary mismanagement) is larger.

Proponents of the fiat system argue that it enables more monetary policy tools to stimulate or control the economic cycle, by varying the money supply and interest rates. These tools have been used with varying degrees of success in the past.

Some fiat currencies, such as the US dollar and the Euro, are recognized internationally, and are used for global trade, because they are backed by some of the most credible governments and largest economies in the world.

Other fiat currencies have suffered from hyperinflation and lost value, after people lost faith in them. A well-known example is the Zimbabwean dollar (ZWD), with its 100 trillion denomination banknote, which we will learn about in the following section. However, large and leading economies, such as Germany (Weimar Republic, in 1922-1923) and China (1943-1945), have gone through periods of hyperinflation, due to excessive fiat money printing without the backing of sufficient, real economic resources.