I am reading a book on how money works and it has the following definition for fiat currency: "currency with value backed by faith in the government and economy." What does that mean exactly? In particular, what does it mean for currency to be “backed by” something? And faith in the government and economy to do what exactly?
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2 Answers
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We say currency is backed by something if the value of currency is supported by some commodity.
For example, under gold/silver standard a currency would be backed by gold/silver, which means that every note guarantees that you can receive some amount of gold or silver for it. Of course, you can buy commodities such as gold with currency that is not backed by anything, but then you are not being guaranteed some fixed amount (like let’s say to always get 1oz gold for 1 dollar).
Technically speaking fiat currency is not backed by anything. Saying fiat currency is backed by faith is an allegory. The value of fiat currency depends solely on how much they trust they can use it to settle their debts and it has no intristic value. This is in contrast to commodity money or money that are backed by some commodity where the value is derived from intristic value of commodity (fiat money are just paper pictures of dead people or old buildings, silver coin can always be smelted and turned into something useful).
answered Aug 30, 2022 at 20:14
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The quick answer you'll see pretty often is that the USD has value because the US government says it has value. I think that explanation is pretty limited since it misses what that means in a practical sense. Look at any USD bill, it's going to say "This is legal tender for all debts, public and private". "Public" here means that debts accrued from any level of government (think taxes, tolls, court costs, etc.) must be paid in USD. "Private" here means that if you're going to do business in the US, you have to accept USD as a form of payment. All that is to say: so long as there are bills to pay and things to buy that are priced in USD, USD will have value.
What does it mean for currency to be backed by something? Until the '70s, the USD was backed up by precious metals. This means, no matter how bad the US economy got, you could trade in your USD for some fixed amount of gold. As you can imagine, this has the benefit of creating some stability in the valuation of the currency. The downside of this is that your currency supply is linked to your gold supply. If your economy is growing faster than your supply of precious metals then you end up with deflation, which will cause the gears of your economy to seize up.
answered Aug 30, 2022 at 20:16