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Tuesday, May 24, 2011

what is fiat currency?

Formal definition of Fiat money is-
"Fiat money is intrinsically useless and used as a medium of exchange."
Almost every country in the world uses Fiat money standard.

A $ 100 US bill or Indian 1000 Indian rupee note, both are just pieces of paper (intrinsic value of paper is almost 0) but can fetch goods and services much higher than the worth of paper.
On the contrary a gold coin is not a fiat money as it has got intrinsic value of gold.When intrinsic value of money is more than its extrinsic value, money shall disappear.
In India, once there were few coins of Aluminium (5,10 and 20 paisa) in circulation, when Aluminium prices soared high, unscrupulous people collected and melted coins to sell as commodity (Aluminium), as they were getting more return for selling Aluminium than the combined nominal value of all  coins.
So Gresham’s law comes into play which states-"bad money shall drive good money out".
Good money is the money that has nominal value or face value more than its commodity value, while bad money is the money having nominal value more than its commodity value.
If selling a coin as commodity fetches less money than its nominal value, no body shall melt and sell coins as commodity.
In short, it is difficult for good money to survive in the market.

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