Fiat Money

Over time people realized that, carrying gold with them was not a safe practice, in fact it was also not a convenient one either. They then kept their gold and silver with a goldsmith’s place where they paid a small amount of money for the service. The people running the place would then give them a receipt certifying that they indeed had kept the gold away in a locker.

This new invention helped both the buyers and sellers; the sellers knew that the buyers really did have the gold available to pay for the transaction and the sellers found it more safe and convenient to hand over the receipt than to carry the money physically. The seller could then go to the “bank” or “place” where the gold was kept and get it back in return for the receipt.Thus, the receipt or money was then totally backed by gold and the person owning a receipt could go to the bank and retrieve the gold anytime.

During the beginning of our modern day banking system, money was considered a receipt by the government declaring that the person had that amount of gold. A person could always hand over his paper money to another for exchange of a service or commodity thus declaring that the other person was now the owner of the receipt and gold.

The seller of the service or commodity could then go to any bank and claim his gold by handing over the receipt. The method was essentially the same as in earlier times although slightly modernized. Gold was even then the main currency for trade and commerce. This system was known as a fully backed system as the banks had the same amount of gold as they handed over the receipts and is known as 100% reserve banking systems and differs from the one used today. Thus, they would have no problem if all of their customers decided to reclaim their gold on the same day.

The methodology adopted by most of the countries before the world war 1 was based on supplying money to the public that was only partially backed. The banks had the authority to handout receipts to their clients for money that in reality did not even exist. For example, a farmer comes to the bank asking for a loan so as to buy a certain piece of land. The bank would give the farmer a receipt (paper money) upon accepting his request. The bank has thus given out a receipt even though there is not gold backing that receipt. This method is commonly known as the fractional reserve banking system. Here, the bank decides to hand out receipts for gold that doesn’t exist!

Thus, the money is no longer completely backed and the bank has created more money than really exists. Usually, the government sets the reserve requirement which means that the government will decide the exact amount of money that is to be backed. For example, if the government states that a bank must have 20% of the total money in reserve, then the bank will have to retain RM 20,000 in gold if the total outstanding currency of the bank is RM 100,000.

If the reserve requirement set by the government is low, then the bank can lend out more receipts and hence distribute more money into the economy. However, the bank will have to limit its loans if the reserve requirement set by the government is high.

Eventually, the gold backing of money was totally abolished in August 15, 1971 when President Nixon suspended the gold payments. Thus, the money that we have today is fiat money, which is not backed by gold. We no longer use paper money that is really a receipt for gold but instead the fiat money has taken over as the medium of exchange.

Some countries have devised a solution to stabilize their currency whereby they peg their currency to that of the United States. This is done based on the preconceived notion that the U.S currency is comparatively the most stable currency available. This is the case in Malaysia as its government has declared that 1 U.S Dollar is now the equivalent to 3.8 Malaysian Ringgits. Any inflation or deflation on the part of the dollar will definitely have a profound effect on the Malaysian currency.