This article is the second in a series. You can read part one here.

What is the United States Dollar Based On?

In the first part of this series, I talked about the Gold Standard backing the United States Dollar, and how we have since abandoned it. As a country, we and many other nations have moved from an equity-based currency system to a debt-based currency system which is called a fiat system.

Ah, fiat. People in the cryptocurrency space throw this word around a lot, but what does it actually mean? The answer is a bit complicated, but stick with me.

Fiat money is a unit of currency which has value for no reason other than that the issuing authority claiming so. In the case of the dollar, the United States Government prints dollars, and tells us that the dollar has value and will continue to do so. But why do we believe them?

Any sort of money must inherently carry three values: it must be able to store value, it must be widely accepted in exchange for goods and services and it must be divisible in order to satisfy small and large debts. Because governments are able to mandate that fiat currency is the only way to pay debts to the government, the currency is backed by faith in that government so long as they continue to accept it. Since the government accepts the dollar as legal tender, so do the citizens as long as they have faith in that government.

The value of the dollar in relation to other currencies is set by the rate at which foreign entities (banks, individuals and businesses) place their trust in the United States Government to hold that value. In essence, the value of the dollar is based upon how much foreign entities believe it should be worth. This can be influenced by a great many factors however, and this makes any form of fiat money vulnerable to a lack of faith in its purchasing power and inflation.

Causes of Fluctuation in Value

Simple economics tells us that the price of any asset is determined by the laws of supply and demand. If there is a great supply of any asset, but low demand, the value of that asset will fall. If the demand exceeds the supply however, the price rises. This is true of any asset, and the dollar is no exception. So what causes supply and demand for the dollar to rise, fall or remain steady?

Let’s start with supply. One of the dangers of a fiat money system is that the controlling government has the ability to print an endless amount of money if they so choose… but if they do, the value of each unit will fall drastically since the money supply far outweighs the demand for that currency. This drastically hurts the economy of a nation, as suddenly the money in your pocket cannot buy nearly as much as it could before.

If the government decides to reduce the monetary supply, essentially destroying money instead of printing it, this causes the currency to gain in value compared to other currencies. The demand exceeds the supply.

Rising and falling interest rates also play a large factor (controlled by central banks), as does the country’s GDP and imports/exports. The important takeaway is that fiat money is based on faith in the issuing government and the continuing stability of that government. This means that instead of maintaining ownership of a physical asset, the owner of a fiat currency note has no control over their net worth or their bargaining power. This is left entirely in the hands of central banks and the government issuing the currency.

Stay tuned for the next article, in which I’ll talk more about the power of central banks and large financial institutions in a fiat money system!

This article is part of a series, you can read part one here!