Fiat money is a currency that a government has declared to be legal tender, but is not backed by a physical commodity. The term derives from the Latin fiat (“it shall be” or “let it be done”) as fiat money did not spontaneously emerge in the free market, but it was established by government regulation or law. Contrary to commodity money, which is money that is at the same time a commercial commodity, fiat money is a legal claim, which derives all its properties from the law. It is neither a commercial commodity, nor a title to any such commodity, so it is irredeemable paper money without any intrinsic value.
Fiat Money and Gold
Historically, most currencies were based on physical commodities such as gold or silver. However, governments could not increase the supply of precious metals at will, so they gradually introduced fiat monies. In 1971, the Bretton Woods agreement collapsed and the convertibility of the U.S. dollar to gold was canceled. Since then, we have been living in a monetary system based on fiat money with mostly freely floating exchange rates. Because fiat money can be theoretically printed without limitation, and because its value is based solely on faith, fiat money can greatly lose its value. The risk of inflation or even hyperinflation (as in Germany in the 1920s) inherently associated with fiat money is one of the reason why gold is considered a safe haven asset. Since its supply is limited and cannot be increased by political will, gold is believed to be a store of value. In other words, the current monetary system based on fiat money, freely floating exchange rates and fractional-reserve banking is instable, which creates demand for safe haven assets, such as gold.
Gold used to be money for thousands of years, whereas our fiat money experiment has been here only since 1971. Thus, when the faith in paper money (particularly in the U.S. dollar) subsides, the unofficial world currency, gold prices, rises. Contrary to paper currencies, gold is a real commodity which cannot be printed and has a certain use value, which sets a bottom for its prices – this explains why there is demand for it in times of distrust in the U.S. dollar system. You can think of gold as an insurance or backup in case of the collapse of the fiat money economy with the greenback as the world reserve currency.
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