What is Fiat Currency?

Fiat money, knowing the meaning of money over time, up to the present day, allows you to:

  • understand the impact of Fiat money on the economic system that uses it;
  • know the reasons and effects of monetary policy;
  • identify factors affecting exchange rates as the price between two currencies;
  • recognize the correlations between economic developments and exchange rates;
  • understand the reasons why exchange rates are always associated with economic news;
  • get a general idea of ​​the correlation between growth, cycle, and change;
  • use this framework idea to interpret the news;
  • and, use this framework idea to think about exchange rate trends.

The first known form of money is the so-called commodity money, that is, a coin with its own intrinsic value (such as gold or silver coins, for example.

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How was a fiat currency born?

The needs of the modern economy have led to the separation of the nominal value of the currency from its own value.

It is the central banks of each country that ensure that the banknotes that are issued by them have legal value and are to be considered valid for the payment of goods and services, beyond their intrinsic value which consists of simple paper or non-metals.

This is the concept of fiat money (legal money) which is opposed to that of commodity money, in which the nominal value of the banknote/currency is completely disconnected from its value as a commodity.

Let’s see very briefly the steps that led to fiat money.

  1. Barter
  2. Commodity currency
  3. Paper currency
  4. Bank money

Barter = exchange of goods without exchange goods.

Commodity money with intrinsic value as a real good is conventionally recognized as a payment instrument to facilitate transactions.

Commodity money is only a means of circulation or exchange.

The means of payment is production.

Production is monetized to carry out transactions.

We arrive at further facilitation of exchanges.

Paper money has the characteristics of a commodity money certificate of deposit.

These Certificates of Deposit can be transferable and convertible on demand into goods and services.

1. From commodity money to paper money

Paper money can therefore be understood as a kind of good commodity.

The amount of paper money in circulation is equal to the amount of commodity money deposited = regular deposits.

2. From paper money to bank money

From regular deposits, with the intensification of commercial and credit activities, we gradually move to irregular deposits.

This means that the paper money in circulation exceeds the amount of commodity money deposited.

In this way the relationship between commodity money deposited and banknotes in circulation are weakened.

The loan to the public is configured as a suitable deed for the multiplication of working capital.

Over time, with the emergence of the state and the strengthening of public powers, we move to legal and banking money issued by a central bank.

The issuers authorized by the states issue legal tender (monetary base).

The other (commercial) banks issue the (writing) bank money that arises from bank credit deeds on the basis of deposits collected from the public.

In these evolutionary processes of “money” the first obvious advantage was that of carrying intrinsic cards of value rather than “bags of precious metal”, this accelerated the exchange processes and made finance take off through the development of circuits dedicated to exchanging coins themselves.

In a short time, the National States all joined and adopted the currencies expressed in cards and putting gold reserves as underlying to the value of the card.

This became a mechanism and was called the GOLD STANDARD.

Through the Bretton Woods agreements of 1944, the value of one ounce of an hour was set at $ 35 (US dollar), all other currencies/currencies were defined in relation to the dollar.

This very rigid, efficient, and transparent system lasted until the oil crises of the early 1970s, when the President of the United States of America, Richard Nixon, decided to suspend the convertibility of the dollar and consequently of all other currencies into gold.

That day the Forex market began the currency market where each currency is free to be exchanged against another.

It was no longer necessary to have a gold equivalent to guarantee one’s own currency, the currency was guaranteed by the central bank that issued it, we can also read between the lines that the value of a currency had become the trust in the sovereign entity behind it.

But in our times, what is meant by Fiat money?

As is now clear and established, the Fiat money is an elusive concept, given the various instruments available on the market to hold liquidity.

Normally different types of monetary aggregates are identified, distinguished by the degree of liquidity, with increasing amplitude as the degree of liquidity decreases, the following terms are always mentioned in central bank reports and constitute the monetary aggregates:

M1 = outstanding + current account deposits

M2 = M1 + deposits up to 2 years + deposits repayable with notice up to 3 months

M3 = M1 + M2 + money market securities / money market fund shares + securities maturing 2 years

M3 is the most monitored aggregate, as it is the largest.

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