Fiat Currency Explained

The First World War placed enormous strain on gold reserves. Governments suspended convertibility to finance military spending.

The interwar period exposed serious flaws in the gold standard. Economic imbalances, deflation and rigid monetary policy contributed to instability. Britain left gold in 1931 during the Great Depression.

After the Second World War, the Bretton Woods system attempted a compromise: currencies were pegged to the US dollar, and the dollar was convertible to gold at $35 per ounce.

This arrangement ended in 1971 when President Nixon suspended dollar convertibility – the so-called ‘Nixon Shock’. By 1973, the world had moved decisively to floating fiat currencies.

For context on how the UK monetary system evolved through these changes, see Decimalisation in the UK.

Modern fiat systems operate through central banking and active monetary policy. Rather than relying on gold reserves locked in vaults, today’s system is managed by institutions designed to maintain stability, control inflation and support economic growth.

In the UK, the Bank of England plays a central role. It does not simply print money – it carefully manages financial conditions across the entire economy. It does this through several key tools:

• Interest rate adjustments – raising rates to cool inflation or lowering them to stimulate borrowing and spending.
• Quantitative easing (QE) – creating new money electronically to purchase government bonds and inject liquidity into the financial system.
• Open market operations – buying or selling financial assets to influence short-term interest rates and banking reserves.
• Regulation of commercial banks – ensuring banks hold sufficient capital and operate safely within the wider monetary system.

Unlike a gold standard, fiat currency is not limited by physical bullion reserves. The money supply can expand when needed. For example during a recession or financial crisis. This flexibility is one of the defining features of modern monetary systems.

However, expansion is not unlimited. If too much money is created too quickly, inflation erodes purchasing power. The balancing act between growth and price stability is at the heart of central banking.

If you would like to explore how economists measure money – from notes and coins to digital deposits and broader liquidity aggregates – read What is the UK monetary supply?

It is also important to recognise how digital modern money has become. Physical notes and coins account for only a small proportion of total money in circulation. The vast majority exists electronically – as bank deposits, transfers and balances recorded on financial institution ledgers. In practical terms, most fiat money today is simply numbers on screens, backed not by gold, but by confidence in the system itself.

Critics argue that fiat systems are only as strong as the institutions that manage them. Because fiat money is not anchored to a physical commodity, it depends heavily on credibility, restraint and public trust. When those foundations weaken, instability can follow.

1. Inflation Risk

If governments or central banks expand the money supply too rapidly relative to economic output, prices tend to rise. Moderate inflation is common, and often targeted deliberately, but sustained increases erode purchasing power over time. Savers, pensioners and those on fixed incomes can be particularly affected if wages fail to keep pace with rising costs.

2. Hyperinflation

In extreme circumstances, loss of confidence can spiral into hyperinflation. Historical examples such as Weimar Germany in the 1920s or Zimbabwe in the 2000s demonstrate how rapid money creation, fiscal mismanagement and collapsing trust can render a currency virtually worthless. In such cases, citizens often turn to foreign currencies, tangible assets or precious metals as alternative stores of value.

3. Political Influence

Although many central banks are formally independent, monetary policy does not operate in a vacuum. Governments facing elections or fiscal pressure may favour looser monetary conditions to stimulate short-term growth. If discipline weakens, long-term stability can suffer. The credibility of a fiat system therefore relies not just on economic expertise, but on institutional independence and transparency.

Ultimately, because fiat currency is not backed by gold or another tangible asset, its value rests on collective confidence. When people believe in the stability of the system, it functions smoothly. When trust erodes, volatility increases. In that sense, the strength of fiat money is inseparable from the strength of the institutions that support it.

Under a Gold Standard:

• Supply is constrained by mining output – the money supply expands only as quickly as new gold can be extracted and added to reserves.
• Money has intrinsic metal value – coins and, historically, banknotes represent a claim on a tangible asset.
• Long-term purchasing power tends to remain more stable – because supply growth is limited, inflation is typically restrained over long horizons.

Supporters argue this creates built-in discipline. Governments cannot simply create more money at will, which reduces the risk of currency debasement.

Under Fiat:

• Supply is policy-driven – central banks adjust the money supply according to economic conditions rather than gold reserves.
• Value is confidence-based – currency derives its worth from trust in institutions, legal frameworks and economic stability.
• Short-term economic management is more flexible – policymakers can intervene during recessions, financial crises or shocks.

Supporters of fiat argue that modern economies are too complex and dynamic to be constrained by gold supply. The apparent obsession with achieving growth at any cost, lends itself more to a fiat-based financial system. Critics counter that flexibility can slide into overexpansion.

For a deeper side-by-side analysis, see Gold vs paper money.

This debate also raises an important conceptual question: Is gold a commodity or currency? Gold occupies a unique position. It is traded like a commodity, yet held by central banks as a monetary reserve. Understanding this dual role helps explain why gold remains central to monetary discussions – even in a world where no major economy formally ties its currency to it.

At present, no major economy operates under a classical gold standard. Every leading currency, from the pound to the dollar and euro, functions within a fiat framework. A return to gold backing would not be a minor policy adjustment; it would represent a fundamental restructuring of the global financial system.

Such a shift would likely require:

• Massive revaluation of gold – existing gold reserves would need to support vastly larger modern money supplies, implying a dramatically higher gold price.
• Severe monetary contraction – governments would have to limit money creation, potentially triggering deflation and economic slowdown.
• Structural changes to global trade – exchange rates, capital flows and international settlements would need to be redesigned around fixed metal convertibility.

In an interconnected global economy with complex credit markets and digital payment systems, implementing such changes would be extraordinarily disruptive.

For these reasons, fiat currency remains the foundation of global finance. It supports modern banking, international trade, sovereign debt markets and digital payment networks. The scale and speed of today’s economy would be difficult to reconcile with a rigid commodity constraint.

However, fiat’s long-term sustainability is not automatic. It depends on disciplined monetary policy, credible institutions, political stability and – above all – public confidence. When trust in currency weakens, volatility rises. History demonstrates that monetary systems evolve when economic or political pressures make existing arrangements untenable.

Fiat currency may be dominant today, but its durability ultimately rests on the strength of the institutions and governance that sustain it.

What is fiat currency in simple terms?

Fiat currency is money that has value because a government declares it to be legal tender, not because it is backed by a physical commodity like gold or silver. Its value depends on public confidence, economic stability and central bank policy rather than intrinsic metal content.

What is the difference between fiat money and the gold standard?

Under a gold standard, money is backed by physical gold reserves and can be converted into gold. Under a fiat system, money is not backed by any commodity and its supply is controlled by central banks. Gold-backed systems prioritise stability and constraint, while fiat systems prioritise flexibility and economic management.

Why do governments use fiat currency instead of gold?

Governments use fiat currency because it allows greater flexibility in managing the economy. Central banks can adjust interest rates, increase liquidity and respond to financial crises without being limited by gold reserves. This flexibility supports modern banking systems and global trade.

Can fiat currency become worthless?

Yes, fiat currency can lose significant value if confidence collapses. In cases of hyperinflation – such as Weimar Germany or Zimbabwe – excessive money creation and economic instability led to currency failure. However, in stable economies with credible institutions, fiat currencies generally maintain value.

Is gold still important in a fiat currency system?

Yes. Even in a fiat system, central banks hold gold reserves as a store of value and financial safeguard. Gold acts as a hedge against inflation and currency instability, which is why it remains relevant despite no longer formally backing modern currencies.