Money issued by modern-day governments and central banks is not convertible into a commodity (e.g., gold or silver). Notes and coins have minimal intrinsic value (see picture below for one suggestion), but they are made legal tender by ‘fiat’ or order of the government. But why do we accept worthless pieces of paper or deposits convertible into worthless pieces of paper?
According to Larry White, people accept fiat money because when the convertibility of government money into gold was abolished, the fiat money retained the old specie unit of account (e.g., pound sterling). In effect, nothing had changed and the practice of accepting them was self-reinforcing.
Others argue that fiat money has value (and is therefore demanded) because of its usefulness as a medium of exchange. In others words, fiat money has value because others will accept it as a medium of exchange (there is a network effect in operation here). However, the late Earl Thompson saw that there was a backwards induction problem with fiat money – “the world’s last sale of a real asset in exchange for an inconvertible paper currency is apparently conferring a worthless object on the seller, who should then be unwilling to surrender a positive amount of any valuable real asset in exchange for the paper”. According to Thompson, governments can give fiat money value in the last period by requiring that future taxes be paid with it. In other words, there is another source of demand for fiat money aside from its use as a medium of exchange. You can read Thompson’s work on this by clicking here.
David Glasner also has an excellent post on this issue – click here.
