NationStates Jolt Archive

How the hell does fiat currency work? The money has no intrinsic value, and yet everyone accepts it as a medium of exchange. There's no real value backing up the currency. So why does anyone accept it as payment for anything?

they are conditioned to do so.

My kids have poker chips, that have no real value, but if you take one away they freak out, because they know that it costs 4 poker chips to watch a TV show.......

But in your case, your kids know that you'll accept poker chips in exchange for stuff. So the chips have instrumental value, and that value is mostly fixed.

If the government requires that vendors accept currency in exchange for goods and services, then the same applies in the real-world economy. however, since the bank notes have no intrinsic value and there are no price controls, shouldn't that lack of intrinsic value lead to massive inflation?

I just don't get it. It doesn't make any sense to me.

yeah, I don't know. ;)

The money has no intrinsic value, and yet everyone accepts it as a medium of exchange.

well, we don't really think that things that actually have intrinsic value should be used as mediums of exchange. hell, in many cases we'd hold that things that are intrinsically valuable shouldn't be exchanged at all.

It does have intrinsic value. It represents the amount of energy and materials that go into the production of goods and services. The amount that a dollar represents may flucuate wildly, but in essence that's what it does represent.


By the way, because of the run up in commodity prices a penny now has more than 1 cents worth of copper and a nickle now has more than 5 cents worth of nickle in it.

to answer the question without going into a philosophic debate on the topic of intrinsic value, we can probably just go through example.

there is no thing in the universe that is intrinsically 'the meter'. but we can all agree to use it as a standard for measuring things

to answer the question without going into a philosophic debate on the topic of intrinsic value, we can probably just go through example.

there is no thing in the universe that is intrinsically 'the meter'. but we can all agree to use it as a standard for measuring things

yes

they are conditioned to do so.

My kids have poker chips, that have no real value, but if you take one away they freak out, because they know that it costs 4 poker chips to watch a TV show.......

30 years later, your children will be at a Gamblers Addict Anonymous meeting! :D

But in your case, your kids know that you'll accept poker chips in exchange for stuff. So the chips have instrumental value, and that value is mostly fixed.

If the government requires that vendors accept currency in exchange for goods and services, then the same applies in the real-world economy. however, since the bank notes have no intrinsic value and there are no price controls, shouldn't that lack of intrinsic value lead to massive inflation?No, because the real economy is actually a lot like Smunkee's token economy. Her kids almost certainly have to earn those chips somehow, rather than just going to a store and buying a bag or 2 of them. Therefore the supply is limited.

Similarly, in the Real Money economy, the ability to get ahold of more money is limited; its availability to a person is connected to that person's ability to invest, work for, or otherwise procure it. And it's illegal to just print up or mint your own.

This limits the supply and adds value to the currency.

30 years later, your children will be at a Gamblers Addict Anonymous meeting! :D
somehow I doubt that. ;)

Fergi America;11645976']No, because the real economy is actually a lot like Smunkee's token economy. Her kids almost certainly have to earn those chips somehow, rather than just going to a store and buying a bag or 2 of them. Therefore the supply is limited.

Similarly, in the Real Money economy, the ability to get ahold of more money is limited; its availability to a person is connected to that person's ability to invest, work for, or otherwise procure it. And it's illegal to just print up or mint your own.

This limits the supply and adds value to the currency.
actually you are right, they came home with poker chips from my mom's set once and tried to "spend them" but I pointed out that they were worthless being counterfeit and all.

It does have intrinsic value. It represents the amount of energy and materials that go into the production of goods and services. The amount that a dollar represents may flucuate wildly, but in essence that's what it does represent.
But why does it represent that? Because the government says so? Do they enforce the legal tender laws?
to answer the question without going into a philosophic debate on the topic of intrinsic value, we can probably just go through example.
It's clearly true that people do value money, but should they? What's the source of currency's value?

This might end up being a philosophical discussion. I just don't see why people value the money if it's not guaranteed to be exchangeable at something close to a fixed rate for something with real value.

It is all convention.

Gold, you must remember, only has fiat value - it is not edible, you can't live in it, it doesnt keep you warm in the winter.

When people agree that gold is valuable though, it becomes fiat money which can be traded for things that provide utility. The exact-same thing is true with paper money or currency accounts.

Fergi America;11645976']This limits the supply and adds value to the currency.
There's a limited supply of these saucers of mud in my yard, but that doesn't make them valuable.

Again, I understand that money appears to have instrumental value in that it's exchangeable for goods and services, but what I don't get is why it's exchangeable for goods and services.

There's a limited supply of these saucers of mud in my yard, but that doesn't make them valuable.

Again, I understand that money appears to have instrumental value in that it's exchangeable for goods and services, but what I don't get is why it's exchangeable for goods and services.

Because everyone agrees that it is.

That is the only reason.

Fiat currency has value because the state says it has value, and because the marketplace puts a value on it, both occuring concurrently. It is used to represent a unit of labor.

Beyond that, even gold is without any intrinsic value. It only gains value once people give it value.

But why does it represent that? Because the government says so? Do they enforce the legal tender laws?Yes, and yes.
And, people have come to the conclusion that it's better to go along with that, probably because it makes things a heck of a lot more convenient than a barter economy.

There's a limited supply of these saucers of mud in my yard, but that doesn't make them valuable.That's just a marketing problem.
People HAVE sold mud, after all, and not just to LG! Sometimes for a bunch of...you guessed it, money. Mud baths, mud facial cleanser/skin conditioner... Market it right and you'll move your limited supply of muddy saucers just fine :D

Businesses and consumers agree that it has value and know that its value is supported by their government, so it works perfectly. The government enforces its value as legal tender, and people are willing to accept it as such because of the government backing; it's a lot more convienent than heavy gold coins and more abundant than backed currency, so it is more useful to businesses and consumers. Even so, the physical supply of legal tender pales in comparison to the actual amount of money in circulartion

Honestly, gold is no different than fiat money...it's the metal version of paper currency. People believe it has value and are willing to hold it because it is valued by others. If people stopped valuing gold, it would become as worthless as dirt just like paper money. The only reason we value it is because our society has valued it throughout history; gold's value is purely historical and cultural rather than due to any real utility. 91% of the world's gold is made in to jewelry or held by investors, compared to 8% used in all industrial purposes. It is only valuable because people say it is valuable. If the supply of gold soars, so too does inflation; increasing the gold supply is no different than printing more money.

read this...

http://www.galmarley.com/framesets/fs_fiat_money.htm

and the other articles at that site are vastly insightful as well.

Because everyone agrees that it is.

That is the only reason.
That's an acceptable answer.

Though I'm tempted to ask why any of them hold that opinion. It seems somehow irrational.

That's an acceptable answer.

Though I'm tempted to ask why any of them hold that opinion. It seems somehow irrational.

only irrational if the money didn't have an agreed upon value, it's rational to me because I can buy things I need with it, I know it's just paper, but it's paper that gets my kids food and medicine, so it's valuable to me.

Beyond that, even gold is without any intrinsic value. It only gains value once people give it value.

In the early Iron Age, iron was more valuable than gold. However, as mining technology improved the supply of iron soared and its value declined...just like printing more money can destroy the value of a currency. Iron is more useful than gold and was actually more valuable then gold, but once its supply increased it plunged in value and lost its utility as currency.

If jewelry demand were to ever fall or a new metal became more popular than gold for jewelry, gold would become worthless overnight.

only irrational if the money didn't have an agreed upon value, it's rational to me because I can buy things I need with it, I know it's just paper, but it's paper that gets my kids food and medicine, so it's valuable to me.
Oh, absolutely. Once everyone else values it, too, it makes perfect sense to use it as currency. But getting to that point required someone to value something that wasn't good for anything.

Oh, absolutely. Once everyone else values it, too, it makes perfect sense to use it as currency. But getting to that point required someone to value something that wasn't good for anything.

It doesn't even need everyone to value it, just two people.

Oh, absolutely. Once everyone else values it, too, it makes perfect sense to use it as currency. But getting to that point required someone to value something that wasn't good for anything.

Gold has uses, but the amount used for industrial purposes is miniscule compared to the amount held by investors or used in jewelry. If something comes along that replaces gold in jewelry, demand for gold would fall by at least 75% or even up to 91% as investors dump the now worthless metal in favor of the new one.

Fiat paper money is used because it's convienent and its supply can be controlled much more easily than precious metals. There's no risk of a mine being exhausted and cutting off the gold supply, nor is there a risk of a conquest or new discovery flooding the market with huge amounts of precious metals; you can simply tell the central bank and treasury to produce X amount of money and let it go from there; if there is a sudden shift in demand, the money can be removed from the economy or more can be printed to keep up with the economy.

That's an acceptable answer.

Though I'm tempted to ask why any of them hold that opinion. It seems somehow irrational.

Have to look at the process for creating a currency to see why its rational:

The barter system has serious limitations, limitations which become more serious as a population grows and comes into contact with other populations.

It becomes enormously more efficient to establish some sort of common currency to use in trading. < rational

Rare materials make the best currency because of their rarity, gold is especially good because it is resistant to corrosion and can be easily reshaped and weighed, among other things. Rarity of modern national fiat currencies is very zealously guarded by governments, huge expense is devoted to making currency hard to counterfeit. < rational

Once a currency is established, it is difficult to disestablish. If all trade is done in gold tokens, and you or I decide that we will no longer accept gold tokens for our grain, though all other farmers and gain merchants still will, then we will lose a lot of business. < rational

The more deeply currency becomes entrenched, the less rational it is to stop using it, both from a strictly self-interested standpoint and one concerned with broader efficiencies. < rational

Once a currency is established, it is difficult to disestablish. If all trade is done in gold tokens, and you or I decide that we will no longer accept gold tokens for our grain, though all other farmers and gain merchants still will, then we will lose a lot of business. < rational

And, much like barter the coinage system has limitations as trade volumes increase; eventually, trade volumes will grow to millions of coins or more and individual merchants will be dealing in quantities of thousands of tokens for goods making the system increasingly inconvienent (after all, thousands of gold coins are heavy making them difficult to transport). So, the state will respond by issuing paper or other token currency backed by those gold coins as a replacement for the less efficient coinage system.

Eventually, the volume of trade in the economy starts to strain the limit of gold production, and other economic shocks will result in sudden surges in demand for money (i.e. a war or a major economic stimulus plan) and so the government will shift to fiat money backed by the strength of the government itself. If the government can back its currency, people will use it and gold will no longer be needed to back it because the economy accepts it as a store of value to be used in the purchase of goods and services.

Barter-Metal Coins-Gold Certificates-Fiat Money is simply a rational evolution of the monetary system.

you can simply tell the central bank and treasury to produce X amount of money and let it go from there; if there is a sudden shift in demand, the money can be removed from the economy or more can be printed to keep up with the economy.


how do they do that practical? they can't just hand the money out and steal it back when they have to? [/economy noob]

The barter system has serious limitations, limitations which become more serious as a population grows and comes into contact with other populations.

It becomes enormously more efficient to establish some sort of common currency to use in trading.

unfortunately for that story, money was not in fact invented because barter was inefficient. barter doesn't seem to actually have much to do with the origin of money at all.

to answer the question without going into a philosophic debate on the topic of intrinsic value, we can probably just go through example.

there is no thing in the universe that is intrinsically 'the meter'. but we can all agree to use it as a standard for measuring things

I believe a meter is an even division of the distance between the Earth's poles. One-millionth? Ten-millionth? Something like that.

I believe a meter is an even division of the distance between the Earth's poles. One-millionth? Ten-millionth? Something like that.

no, that was just a thing that was thought to fit the required "about this big" to better define a socially created custom. nobody ever said, "aha! i've discovered the meter!" and they certainly didn't discover that the distance travelled by light in absolute vacuum in 1/299,792,458 of a second was the natural base unit of measuring length.

how do they do that practical? they can't just hand the money out and steal it back when they have to? [/economy noob]

Actually, the bulk of money in the economy is not currency; only about 8% of the money supply is actual coins or bills while the rest is held as various bank accounts, certificates of deposit and other kinds of investments. In order to control the money supply, the Federal Reserve controls the ability of banks to lend money. They do this in two main ways (this might sound complicated):

1. Raising interest rates. This works in two ways:

First, it increases the cost of borrowing money from the Federal Reserve to meet reserve requirements (the amount of money banks have to hold to insure their deposits). This makes it less likely for a bank to lend out money beyond its reserve ratio because it will have to pay more to borrow money from the Fed to cover its additional reserve requirements, so the amount of money created by lending is decreased, reducing the money supply.

Second, it makes it more expensive for companies and people to borrow money, which means they will be less likely to take out a loan to buy a new car/house or invest in new production; this reduces both the money going in to the economy as well as demand for new goods and services, further slowing inflation by reducing demand for money as well as demand for raw materials through slowing the economy.

2. Increasing the reserve ratio:

Banks have to hold a certain percentage of the value of their bank deposits in their vaults as cash to prevent bank runs and to have money on hand for whenever an account holder withdraws from their checking or savings account. This is currently 10% in US banks; in other words, if you have $1000 in your bank account the bank will have to keep $100 on hand for your account. The remaining $900 can be lent out and will eventually work its way through the banking system until a total of $10,000 is created by lending and depositing the original deposit.

If the reserve ratio is increased to 20%, the total amount of money that can be lent out is $800 instead of $900; this circulates through the banking system and eventually produces $5,000 in money. That's $5,000 less than at the old ratio and would be a significant change in the money supply.

Generally, the reserve ratio is only adjusted after a severe economic event; for example, if the economy is showing signs of growing too fast the ratio might be increased to halt it before it crashes, or if there is a stock market crash the ratio might be decreased to compensate for the lost money.

unfortunately for that story, money was not in fact invented because barter was inefficient. barter doesn't seem to actually have much to do with the origin of money at all.

The barter system produces several goods with money-like properties; for example, salt, crops, and animals all emerged as benchmark stores of value for comparing the cost of different goods. It reachesd its limit as trade expanded; for example, you might produce a surplus of grain and cattle but want copper tools from a neighboring city. However, they also produce a surplus of grain and cattle making your goods undesirable; however, they do need wood, which another city produces but the wood producer needs salt, which that city doesn't produce. Another city produces salt, but needs grain and cattle; so, in order to get the copper tools you have to trade the grain and cattle for salt which you trade for wood to trade with the other city for the copper tools. Obviously, this system becomes inefficient and merchants start to develop ways to create objective stores of value in order to trade regardless of what goods the city needs and produces.

Eventually, that evolved in to various symbolic representations of goods which eventually became metal coins as precious metals became accepted as a universal store of value. Barter has major limitations that necessitated new means of valuing goods and services; it wasn't so much "inefficient" as it was unable to accomodate the expanding economic diversity and growth in trade during the Bronze Age. Smaller, more isolated and more self-sufficient places functioned perfectly fine using barter even after it had been displaced by coins or paper money in larger countries; it's not inherently inefficient, just less useful as the scale of trade grows larger.

Eventually, that evolved in to various symbolic representations of goods which eventually became metal coins as precious metals became accepted as a universal store of value.

nah, the symbolic representations predate barter (which is exactly the same as other market systems anyway). money originates in the gift.

Once a currency is established, it is difficult to disestablish.
Not that difficult. The wage and price controls in postwar Germany created an enormous black market with currencies of American cigarettes and cognac. The Mark became effectively worthless.

It doesn't even need everyone to value it, just two people.
Someone had to be first.

nah, the symbolic representations predate barter (which is exactly the same as other market systems anyway). money originates in the gift.

I always thought they were used simultaneously, with the symbolic tokens gradually replacing barter and then being replaced with coinage; the Xia in China were using cowrie shells as currency to trade with other tribes, but those other tribes also traded in goods.

Not that difficult. The wage and price controls in postwar Germany created an enormous black market with currencies of American cigarettes and cognac. The Mark became effectively worthless.

Gresham's law; the Mark only became accepted once the controls were ended and the market system could function properly. The same thing happens today in prisons and other places where there is no system of currency and the supply of goods is heavily controlled.

Someone had to be first.

Usually the person who develops the system is the first, and ideally they are the head of the government or treasury when they do it. Or, on a smaller scale without a central government, they're the richest person in the area.

Not that difficult. The wage and price controls in postwar Germany created an enormous black market with currencies of American cigarettes and cognac. The Mark became effectively worthless.



So, it took a world war and the destruction of an economy... "not that difficult" indeed.

Was american money still valuable?

the Mark only became accepted once the controls were ended and the market system could function properly.
Hurray for Konrad Adenauer!

And people wonder why I think socialism is dumb.

I always thought they were used simultaneously, with the symbolic tokens gradually replacing barter and then being replaced with coinage; the Xia in China were using cowrie shells as currency to trade with other tribes, but those other tribes also traded in goods.

what the symbolic tokens took over was increasingly ritualized gift giving, and the social rules governing this gifting were always very distinct from barter. attempting to bargain for the symbolic objects would be seen as a very serious insult for much of the time they were in use. in so far as you ever did use barter in such economies, you did it with enemies.

a sort of general path followed went from gifting, to ritualized gifting, to ritualized gifting of particular sorts of items given social importance/prestige, to eventually using those prestige granting items to exchange for other items.

How the hell does fiat currency work? The money has no intrinsic value, and yet everyone accepts it as a medium of exchange. There's no real value backing up the currency. So why does anyone accept it as payment for anything?

Because the only purpose money serves is to serve as a counting token for making trade more convienient. A temporary substitute, a placeholder, that's all.

Take this hypothetical situation. I make shoes. I want to purchase meat, but here in a hypothetical barter system, the butcher doesn't want or need any shoes, and is thus unwilling to trade with me. If, however, we abstract our trade out to a universally traded commodity that stands as a representative/placekeeper/token of the economic value otherwise contained in shoes or meat, like money, I can now trade with the butcher. I give him money, I get the meat I need, and the butcher can then use the money to trade for whatever else he needs.

At no time does the money itself need to have intrinsic value in order for this to work; way back in the day of the city-states, money often took the form of small rocks, bone fragments, or notches in stones. There is the issue of inflation, and rarity is cited as being what gives things like gold its value in preventing inflation, however, inflation is not a necessary result of paper, or other "fiat" money, in and of itself.

Gold, you must remember, only has fiat value - it is not edible, you can't live in it, it doesnt keep you warm in the winter.


Not quite; Gold is seen to be valuable because it is relatively rare. Scarcity coupled with high demand (for whatever reason, industrial, electrical, or simply as shiny jewelry) means a high price or value. This is one advantage that gold has over paper money; the government can cause inflation by pushing more government backed paper tender through the presses. Of course, this isn't the fault of paper money, but of potentially poor economic policy.

Of course, once we get good at producing artificial gold, like they're doing with diamonds now, all the above goes out the window.

When you deal in fiat currency, you are not really trading something material (gold, silver, etc.) but rather you are trading in trust--you trust that the money you give (or receive) can later be exchanged for something else. It all depends on whether or not you think that anyone else will take your dollar (or pound, or euro, or whatever) and give you what you need.

Fiat currencies don't always work perfectly--in India, for example, the Central Bank has said that as long as a monetary note has a serial number, it can be torn, crumpled, dirty, etc. and it is still legal tender. But try buying ANYTHING in Delhi with crumpled notes, and you just can't. People won't take them--on the sole basis that they believe nobody else will take them either. They refuse damaged notes because they think everybody else does, too--and they're right. But if there was a sudden shift in consciousness and people realized that they really could trade with damaged notes, a substantial portion of India's paper money could be reintroduced. With a fiat currency system, it's a self-fulfilling prophecy--if people think it will work, it will work; if people don't think it will work, it won't work.

And if you have a hard time wrapping your mind around the idea of fiat currency (as I did to begin with), don't even begin to contemplate credit cards--"here, I'll just take this now without giving you anything for it, and I PROMISE, cross my heart and hope to die, that I'll pay you at the end of the month." Whoever came up with THAT idea certainly could have pursued a career in theoretical economics.

Fiat currency works as a promise to pay eventually, so technically you're always in debt. But it all circles around. With gold or silver, or in my nation's case: copper, you are sort of bartering, but using a sole medium. I think we should bring back silver and remint the old pillar dollars...with a slight US modification, like United States instead of FERDND-VI...I have a replica (my favorite coin). :)