How the Fiat System Works
The global monetary system is what’s called a Fiat system in which money is a storage medium for purchasing power and a substitute for barter. Each dollar bill, euro, yen, gold ingot, or whatever currency you choose enables you to buy things as the need or want arises, thus making the barter system (trading one service or product for another) mostly obsolete.
Money then enables enterprises to develop and societies to establish subspecializations, thus fostering a sort of dynamic progression toward the future. For example, before there was money, anyone who owned land produced their own necessities and traded the surplus with other people for the things they needed.
Money changed that system by its inherent ability to store purchasing power, thus giving people the opportunity to make plans for the future and to specialize. In other words, if you’re a good wheat farmer, then you can specialize in wheat, and buy your equipment, hire workers, and look for neighbors’ land to buy to expand your wheat farm.
Markets and central banks then value the relative worth of the paper (currency) based on the perception of how a particular country is governing itself, the current state of its economy, and the effects the interplay of those two factors have on interest rates.
Most of the world’s money is called fiat money, meaning it is accepted as money because a government says that it’s legal tender, and the public has enough confidence and faith in the money’s ability to serve as a storage medium for purchasing power.
A fiat system is based on a government’s mandate that the paper currency it prints is legal tender for making financial transactions. Legal tender means that the money is backed by the full faith and credit of the government that issues it. In other words, the government promises to be good for it.
Fiat money is the opposite of commodity money, which is money that’s based on a valuable commodity, a method of valuation that was used in the past. At times, the commodity itself actually was used as money. For instance, the use of gold, grain, and even furs and other animal products as commodity money preceded the current fiat system.