Fiat 101

Fiat 101: Understanding Government-Issued Money

Fiat money is currency issued by a government and not redeemable for a fixed quantity of a commodity such as gold. The U.S. dollar is fiat currency and legal tender. Its purchasing power reflects many factors, including monetary and fiscal policy, productivity, supply and demand, financial conditions, and public confidence.

A brief U.S. monetary history

U.S. monetary arrangements changed over time. Domestic redemption of currency for gold was restricted during the 1930s. In August 1971, the United States suspended the remaining convertibility of dollars into gold for foreign official holders, ending the central feature of the Bretton Woods system. Describing these separate events accurately avoids the mistaken idea that ordinary bank customers could redeem dollars for gold until 1971.

How bank money and reserves work

Commercial banks create deposit balances when they make loans, while remaining subject to capital, liquidity, risk-management, supervision, and settlement constraints. The Federal Reserve reduced reserve-requirement ratios on transaction accounts to zero effective March 26, 2020. As a result, the familiar textbook example of a fixed 10% reserve requirement and a mechanical ten-times money multiplier does not describe the current U.S. framework.

  • Bank deposits are liabilities of the bank, not physical cash held separately for each customer.
  • Eligible deposits may be insured subject to FDIC rules and limits.
  • Central-bank reserves are used by eligible institutions for settlement; they are not the same as customer deposits.

Inflation and purchasing power

Inflation is a broad rise in prices over time. It reduces what a unit of currency can buy, but its causes can include changes in demand, supply constraints, wages, expectations, commodity prices, monetary conditions, and fiscal policy. No single measure or policy action explains every inflation episode. The Bureau of Labor Statistics publishes the Consumer Price Index; readers should state the dates and series used when comparing purchasing power.

Primary references

Educational information only; not economic, legal, tax, or investment advice.