Fiat currency is a type of money that a government declares to be legal tender. Unlike commodities such as gold or silver, which have intrinsic value, fiat currency has value because the government maintains it and people have faith in its value. This trust and government backing make fiat currency the standard medium of exchange in modern economies.

Fiat currency is issued by a central authority, such as a national government or central bank. The term "fiat" comes from the Latin word for "let it be done," reflecting the currency's value as decreed by the issuing authority. Historically, certain fiat currencies were backed by gold. For example, the U.S. dollar was once linked to the gold standard until 1971 when President Nixon ended the convertibility of the dollar to gold. This change marked the full transition to a fiat currency system, where the value of money is not tied to physical commodities. Instead, fiat currency's value derives from the relationship between supply and demand and the stability of the issuing government.

As legal tender, fiat currency must be accepted for all debts, public and private, within the country. This legal status is crucial because it mandates the use of the currency for transactions and tax payments, reinforcing its role as the primary medium of exchange.

Central banks, such as the Federal Reserve in the United States, play a pivotal role in managing fiat currency. They control the money supply through monetary policy tools, including setting interest rates, conducting open market operations, and adjusting reserve requirements. These actions influence inflation, employment, and economic growth.

Fiat currency systems often operate within a framework known as fractional reserve banking. In this system, banks keep a fraction of their deposits in reserve and lend out the rest. This practice expands the money supply through the creation of new credit. For instance, when a bank receives a deposit, it keeps a portion (say 10%) in reserve and can lend out the remaining 90%. The borrower then spends this money, which eventually gets deposited in another bank, allowing the cycle to continue. This process can significantly increase the total money supply in the economy.

Fiat currency offers several advantages. It provides governments with greater control over the economy, enabling them to manage economic stability and growth through monetary policy. It also avoids the limitations of commodity-based currencies, such as gold, which can be subject to supply shocks and limited in quantity.

However, fiat currency is not without risks. Its value depends heavily on the stability and economic policies of the issuing government. Poor management can lead to hyperinflation, where the currency loses value rapidly, as seen in historical examples like Zimbabwe and Venezuela. Additionally, because fiat currency is not backed by a physical commodity, its value can be more volatile and subject to confidence shifts in the government’s ability to maintain its value.

Fiat currency is the backbone of modern financial systems, providing a flexible and adaptable medium of exchange. While it offers significant control and stability advantages, it also requires prudent management to maintain its value and prevent economic instability. Understanding fiat currency's dynamics is crucial for grasping how contemporary economies function and respond to various economic challenges.