Fiat money system means that a currency is no longer backed by physical assets, such as gold or silver. This means that USD 100.00, JPY 1,000, or other currencies are not equal to a certain weight of gold. Instead, the value of each currency derives from the reputation of a national central bank and economic stability. To understand why modern countries enable such a system prevails within the global economy, let us briefly check out the history of money.
History of Money
Over history, human civilization has been inventing commercial exchange systems to smooth their needs. Simply put, the history of money started when people used the barter system. They exchanged one-kilogram gold for ten cows, for example. But such a system has a shortfall: multiple coincidences have to occur. Not all people could afford what their counterparties needed. Therefore, over the centuries, people across the globe invented coinage currencies, such as dinar and dirham. Those currencies are based on a commodity money system that is a single coin has its own value. Coin currency can mobilize easily hand-to-hand.
After World War II, nations agreed to back their currencies based on the US Dollar backed by gold as an underlying. The system is also known as the Bretton-Woods system. However, after 1973 the system collapsed mainly due to the imbalance between the massive supply of the US Dollar against the gold reserve. Therefore, the fiat currency system is the most suitable alternative in the modern economy to smooth transactions worldwide. However, like previous currency systems, fiat currency has some advantages and drawbacks.
The advantages of the fiat currency system
Fiat money is a sound currency if it can do the functions that a monetary unit must perform in a nation’s economy: holding value, providing a numerical account, and enabling exchange. It also has excellent seigniorage, which means it is more cost-effective to generate than a commodity-linked currency.
The country’s central bank plays a prominent role in the fiat currency system. Because fiat currency is not a scarce or stable resource like gold, central banks have far more control over its supply, allowing them to manipulate economic variables like credit supply, liquidity, interest rates, and money velocity. The Federal Reserve in the United States, for example, has a dual duty to keep unemployment and inflation low.
The drawbacks of the fiat currency system
In general, economists believe that excessive money supply increase causes high rates of inflation and hyperinflation. This is one of the disadvantages of the fiat currency system that enables manipulating the growth of money supply in the economy. As such, the stable value of a currency will depend on sound national monetary policies and central bank reputation. There are more potentials for creating a financial crisis with fiat money due to its unlimited supply. Alternatively, a currency tied to gold, for example, is generally more stable than fiat money because of the limited supply of gold.
Why is investment important within the fiat money system?
Investment is essential, as we can see from the drawbacks of the fiat currency system. It will protect our assets in the form of money against recurring inflation. With the various financial products available in the market, people might opt to safeguard their value of money. If you have a conservative investment profile, you can read here to know what type of products you can enter to invest. But if you have a moderate or aggressive investment profile, you can consider stocks investment to gain more profit from the investment. With the higher risk, the higher yield will come up.
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