Fiat Money vs. Legal Tender: An Overview
Fiat money does not have any intrinsic value. What value it has depends on public confidence in the currency's issuer. Legal tender is any currency declared legal by a government. Many governments issue a fiat currency and then make it legal tender by setting it as the standard for repaying debt.
Key Takeaways
- Fiat money has no intrinsic value, while legal tender is any currency declared legal by a government.
- Governments can issue fiat currency and make it legal tender by setting it as the standard for debt repayment.
- The benefit of fiat money is that it gives central banks greater control over the economy, but governments can print too much money and create hyperinflation.
- The U.S. dollar is both fiat money and legal tender.
Fiat Money
Fiat money is not backed by physical commodities, such as gold. Instead, it is government-backed. Most paper currencies today are fiat currencies. Fiat money value is based on the relationship between supply and demand. Fiat holds value because of people’s faith in that nation’s currency.
In the past, governments minted coins or paper money tied to the value of a physical commodity, which could then be redeemed for a set amount of that commodity. Fiat money cannot be redeemed.
The benefit of fiat money is that it gives central banks greater control over the economy, as they can control how much money is printed. Inflation may occur when a government creates too much of a fiat currency, and the money supply increases too rapidly as a result. Governments printing too much money can create hyperinflation.
Legal Tender
Legal tender is any form of payment recognized by a government, used to pay debts or financial obligations, such as tax payments. National currencies, such as the U.S. dollar, are legal tender. In the U.S., the Treasury is authorized to create and issue dollars to the public. Federal Reserve notes and coins are recognized legal tender in the U.S.
Laws ensure nothing other than official legal tender gains enough traction to be used as money in the economy. Notably, checks and credit cards aren’t legal tender—rather, they are money substitutes.
The U.S. dollar is both fiat money and legal tender. In 1933, the U.S. federal government stopped allowing citizens to exchange currency for government gold. The gold standard, which backed U.S. currency with federal gold, ended completely in 1973 when the U.S. also stopped issuing gold to foreign governments in exchange for U.S. currency notes. Dollars are now backed by the U.S. government itself. As legal tender, the dollar is accepted for both public and private debts.
The dollar's value fluctuates with economic conditions and the federal government's management of interest rates. Since the government controls the money supply, it may print more dollars and create higher inflation as needed to influence economic conditions. As changes in public confidence in the U.S. government occur frequently, the value of the dollar may change rapidly even without ongoing federal management.
Special Considerations
Cryptocurrencies are not considered money (i.e., accepted for use) in most parts of the world, as it does not have legal tender. However, El Salvador became the first country in the world to accept bitcoin as legal tender in June 2021.
Meanwhile, some currencies, notably the U.S. dollar, are considered legal tender in countries that issue no currencies of their own. Ecuador, which does not issue a legal currency, has used the U.S. dollar as its legal tender since 2000.This practice of using the U.S. dollar as a country’s primary currency is known as “dollarization.”
FAQs
Fiat money is money that does not have intrinsic value and does not represent an asset in a vault somewhere. Its value comes from being declared "legal tender"-an acceptable form of payment-by the government of the issuing country.
What is the difference between legal tender and money? ›
Legal Tender refers to all U.S. coins and currency that issued by the government. U.S. Cash dollars are also a valid form of legal tender. Nonetheless, federal statutes do not require a seller to accept cash as a form of legal tender for payment of goods or services that were rendered.
What is the difference between real money and fiat money? ›
Fiat money is physical money—paper or coins—while representative money is a check or other form of currency that can be exchanged for physical money in a stated amount. Both fiat and representative money possess the value they claim to have. Fiat money is backed by the government that issues it.
What is the main difference between fiat money? ›
In contrast to commodity-based money, such as gold coins or paper bills redeemable for precious metals, fiat money is backed entirely by the full faith and trust in the government that issued it.
What is a fiat money in simple terms? ›
A fiat money is a type of currency that is declared legal tender by a government but has no intrinsic or fixed value and is not backed by any tangible asset, such as gold or silver.
Is the U.S. dollar a fiat currency? ›
The U.S. dollar is both fiat money and legal tender. In 1933, the U.S. federal government stopped allowing citizens to exchange currency for government gold.
What makes money legal tender? ›
Legal tender is anything recognized by law as a means to settle a public or private debt or meet a financial obligation, including tax payments, contracts, and legal fines or damages. The national currency is legal tender in practically every country.
What is the U.S. dollar backed by? ›
Prior to 1971, the US dollar was backed by gold. Today, the dollar is backed by 2 things: the government's ability to generate revenues (via debt or taxes), and its authority to compel economic participants to transact in dollars.
Which currency is backed by gold? ›
Currently, the gold standard isn't used as the monetary system for any nation. The last country to abandon it was Switzerland, which severed ties between its currency and gold in 1999. Not coincidentally, Switzerland has the seventh largest gold reserve of all countries.
What is the new currency backed by gold? ›
Zimbabwe has introduced a new gold-backed currency called ZiG - the name stands for "Zimbabwe Gold".
The main issue is that fiat money can lend itself to hyperinflation — an economic state in which inflation increases by more than 50% monthly.
What are the risks of fiat currency? ›
Cons of a fiat currency
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.
Is fiat money good or bad? ›
In many cases, however, the risks of a currency not backed by a physical commodity are worth it, as fiat money allows governments the power to establish monetary policies, manage inflation and promote economic stability.
What is the best example of fiat money? ›
Dollar bills are examples of fiat money because there are no physical commodities backing them. Also, the value of a dollar bill is determined by the government.
What is an example of a fiat money? ›
In the U.S., a single dollar was redeemable for gold until 1933. Over the past century, governments have moved away from the gold standard. Currencies now are almost universally backed by the governments that issue them. An example of a fiat currency is the dollar.
Are coins fiat money? ›
Currency notes and coins are known as fiat money. Currency notes and coins are legal tender. They do not have intrinsic value like silver or gold coins.
Is the US dollar legal tender? ›
Paper money
American paper currency comes in seven denominations: $1, $2, $5, $10, $20, $50, and $100. The United States no longer issues bills in larger denominations, such as $500, $1,000, $5,000, and $10,000 bills. But they are still legal tender and may still be in circulation.
What is the US dollar backed by? ›
Prior to 1971, the US dollar was backed by gold. Today, the dollar is backed by 2 things: the government's ability to generate revenues (via debt or taxes), and its authority to compel economic participants to transact in dollars.
What does the constitution say about lawful money? ›
No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title ...
Are pennies legal tender? ›
Section 31 U.S.C. 5103, entitled "Legal tender," states: "United States coins and currency [including Federal Reserve notes and circulating notes of Federal Reserve Banks and national banks] are legal tender for all debts, public charges, taxes, and dues."
