Fiat vs. Representative Money: What's the Difference?

Fiat vs. Representative Money: An Overview

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. Representative money is backed by the issuer's assets or financial instruments. For example, a personal check is backed by the money in the issuer's bank account.

Without backing, either type of currency would be worthless.

What Is Fiat Money?

Fiat money is declared legal tender by the government that issues it. This includes money in circulation such as paper money or coins. Fiat money is backed by a country's government rather than by a physical commodity or financial instrument.

Most coin and paper currencies that are used throughout the world are fiat money. This includes the U.S. dollar, the British pound, the Indian rupee, and the euro.

The value of fiat money is not determined by the material with which it is made. The metals used to mint coins and the paper used for bills are not valuable in themselves. The value of the money is determined by the government.

Fiat money became the norm after U.S. President Richard Nixon decided to abandon the gold standard in 1971. This meant that the U.S. dollar was no longer convertible into gold. The number of dollars printed was no longer directly tied to the amount of gold the government stored.

Inflation Risks of Fiat Money

Fiat money is at risk from inflation. As prices increase, a unit of currency buys less. If the government tries to compensate by printing too much money, the value of its currency drops further.

That was the case in Zimbabwe. Hyperinflation—extremely fast and out-of-control price increases—caused the currency to lose its value. The government began printing banknotes with higher values to keep up with inflation. The country's central bank finally had to stop printing money, causing the Zimbabwe dollar to lose value in the foreign currency market.

The country eventually turned to the U.S. dollar as its base currency.

What Is Representative Money?

Representative money is a portable currency that is backed by a physical commodity such as a bank deposit. Various forms of representative money are still in place, including checks and credit cards. These forms of payment are used today in place of paper money.

Representative money has a long history. Well into the 17th and 18th centuries, furs and other commodities that had recognized value could be used in lieu of cash in transactions. Precious metals like gold and silver were weighed and used as currency. The coins had actual value equal to the value that was stamped on them.

Until 1970, much of the world followed the gold standard. A country that followed the gold standard set a fixed price for gold, buying and selling it at that price. That fixed price was used to determine the value of the currency. So if Britain set the price of gold at £500 an ounce, the value of the dollar would be 1/500th of an ounce of gold.

Key Differences

While fiat money doesn't have intrinsic value, its value is set by the government that issues the currency. Fiat money can be used to buy goods and services because both parties involved in a transaction agree on the currency's value.

Representative money, on the other hand, is valued based on the instrument backing it, whether that's a commodity, asset, or another financial instrument such as a check. Most currencies are no longer backed by commodities. But there are still other forms of representative money, such as checks, money orders, and bank drafts, that can be exchanged for the value listed on the instrument.

Special Considerations

The U.S. severed its ties with the gold standard in 1971, turning its currency into fiat money. As a result, all other national currencies came to be valued against the U.S. dollar. The money is not backed by gold. It has value because the U.S. government says it does.

If a government becomes unstable and inflation becomes a problem, the population may lose faith in the money it prints. The government may respond by printing too much paper money, which leads to hyperinflation. A dollar is no longer worth a dollar in gold.

The Bottom Line

Fiat money has been the dominant form of currency since the United States, and then the rest of the world, dropped the gold standard in the 1970s. That is, the cash has the value that a government attaches to it and does not represent a store of equal value, such as gold.

Representative money is a kind of IOU but it is backed by more than a promise to pay. It is backed by a deposit of cash or some other commodity that is stored by the payer and ready to be handed over to the payee.