Benefits of a Fiat Money System

Critics of the fiat money system say that when more dollars are put into circulation, our currency becomes diluted and the value of each dollar drops. In practice, the fiat system is designed to avoid price volatility. In this video, St. Louis Fed economist David Andolfatto explains the gold standard and discusses its pros and cons.

Video Transcript

[Music playing]

Narrator: Critics of the fiat money system claimed that when more dollars are put into circulation, our currency becomes diluted and the value of each dollar drops, driving prices up. Meaning, it takes more of these devalued dollars to buy the same amount of groceries, gas or whatever.

In practice, however, the fiat system that has existed for the past 40 years is designed to avoid precisely this kind of price volatility.

David Andolfatto: One of the facts about the demand for money is that it can fluctuate very violently in a very short period of time. Banking panics are more likely to occur under a gold standard regime. The reason for this is because during a bank panic (a bank run), people are running to the bank to redeem their bank notes for gold, and the banking system as a whole may not have enough gold to honor all of these redemptions if they were to occur at the same time.

It’s like going to the ATM machine. The ATM machine spits out paper. And now imagine they spit out gold, but there’s only so much gold in these ATM machines. There’s way more claims to this gold than there is gold. So now everybody’s running to the ATM machine, there is going to be no gold left over, but you’re threatening the integrity of the whole banking system may just collapse.

These events have occurred in the past and it’s created great disruptions in the payment system and exacerbated recessions into much, much larger economic contractions.

Under a fiat money system, the government is free to create money and to lend it out temporarily to these distressed banks. So, these distressed banks can take this money and give it to the people who want to withdraw their money, thereby accommodating the temporary, elevated demand for money. When people see that they can go and get their money and that there’s no possibility that the bank’s going to run out of money, the panic subsides. And then the short-term loans can be repaid to the government, and in this way, a fiat money system—an elastic money supply—can help mitigate, or even eliminate, the possibility of a bank run or a banking crisis.

Gold Standard Video Series

• Part 1: How the Gold Standard Compares to a Fiat Money System (2:04)
• Part 2: Gold Standard and Inflation (3:00)
• Part 3: Purchasing Power (3:17)
• Part 4: Benefits of a Fiat Money System (2:23)
• Part 5: The Gold Standard and the Central Bank (1:46)