Fiat money

History shows it is not possible to insulate yourself from the consequences of others holding money that is harder than yours. — Saifedean Ammous.

 

Fiat money is the currency that is exclusively issued and controlled by political authorities; so it is also called political money or state money. 

Most governments establish decrees to privilege the adoption of its own currency. For example, legal tender laws impose the acceptance of the currency when it is offered ("tendered") as payment to extinguish a debt. Legal tender status also implies that the fiat money is the Unit of Account used by official entities to calculate and impose taxes; therefore, exchange rate fluctuations may imply costs like tax liabilities that create friction to the adoption of other moneys. 

Additionally, direct restrictions to the use of competing currencies are frequently imposed. 

A fiat monetary system is controlled through a Central Bank by a state or a group of states. 

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Fiat units can be either physical in the form of notes and coins or digital in the form of commercial banks reserves at the Central BankCentral Bank's plan for assigning those units is known as monetary policy.

Monetary policy should allegedly ensure monetary and financial stability; furthermore, the Federal Reserve has the additional mandate of achieving maximum employment. However, in practice, Central Banks prioritize the monetization of large state deficits.

Central Banks understand monetary stability as constant inflation of "consumer prices" and as a non-volatile exchange rate against other fiduciary currencies. 

Financial stability is defined as the smooth operation of financial entities that are considered too big or too connected to let them fail.

Central Banks' recipe to temporarily decrease unemployment is to trigger an unexpectedly high rate of monetary inflation that rots the value of fiat money, resulting in an accounting trick that benefits borrowers at the expense of lenders. Fiat obligations are therefore partially forgiven, which benefits those businesses with large expending on wages at the expense of workers with pre-existing contracts.

Instead of "stimulating the economy", unanticipated monetary inflation "enslaves the society".

Most service providers do not have the knowledge nor the ability to adapt prices instantly nor uniformly to the unpredicted abundance of financial units, so they end up unconsciously incurring in real loses that are presented in the form of nominal profits.

Due to its poor monetary properties, fiat money is only indirectly used, through money substitutes.

Money Substitutes

The total amount of currency units is called base money.

money substitute is a claim on a definite amount of money, redeemable on demand. 

Money substitutes are therefore generated through lending and settled when the borrower returns the money

 

The kind of money substitutes issued by a custodian are called money-certificates.

A custodian is the borrower that keeps all borrowings as reserve (reserve ratio = 1).

 

Reserve ratio = amount reserved / amount borrowed.


The kind of money substitutes whose issuers practice fractional reserve (reserve ratio <1) are called demand deposits or checking accounts. 

Checking accounts imply the existence of various liquid claims per each fiat unit. In an imaginary scenario where all commercial banks keep the same reserve ratio, the total sum of checking accounts (often referred as bank money) would be equal to:

base money / reserve ratio.

Nevertheless, base money and bank money do not maintain a constant relation.

Individuals do not have access to comercial banks reserves, so the sum of checking accounts plus cash encompass what is generally perceived as available monetary valueThe recognition that "consumer prices" are more sensitive to changes in the total amount of bank money + cash than in the base money led to the study of money aggregates like M2 for example, that is also known as money supply or broad money. Money aggregates consist in the combination of different kind of money substitutes and other financial assets with cash.

Central Banks' main tool for influencing the amount of bank money in short-term, is the manipulation of the rate at which comercial banks lend reserves each other. 

By lowering those interest rates, the market capitalisation of the existing debt tends to grow and the incentives for borrowing increase, so bank money is created.

The opposite effect happens by increasing interest rates.

Fiat money blurs the difference between money and debt for politically connected financial institutions, as any debt issued by them gets backed by the potential issue of costless fiat tokens. The implicit promise of bailout in the event of bankruptcy encourages such entities to incur greater risk and to conceal capital consumption under the guise of accounting profits.

Terms: 

Lending is the giving of an asset in exchange for the promise to pay it back, which is debt.

Granting credit is lending with the connotation of trust in the borrower's ability to pay back. 

Liquidity refers to how easily an asset can be exchanged.