Why Do We Accept Fiat Currency?

Most people have probably wondered, at one time or another, why national currencies gain wide acceptance. Why, for instance, do so many Americans choose to hold and transact in dollars rather than some other currency?

An instinctive answer might be that dollars just so happen to be what most Americans have accepted. If earlier Americans had decided to use a different currency, that would now be the one widely accepted.

On reflection, this answer is not very satisfying. It explains why we will accept a currency once everyone else has, but cannot explain why the first person or people ever to accept the currency chose to do so.

There is actually something solid behind the acceptance of a national currency. At base, we accept it because the government has imposed, and enforces, a tax obligation that can only be settled in that currency. Our need to pay taxes ensures that there is a willingness to obtain the national currency rather than just any currency.

Our willingness to accept the currency as payment for goods and services makes it possible for the government to spend its money into the economy. Some of us will be willing to work in the public sector to obtain it. Others will be willing to transact with public sector employees or the government to obtain it. Still others will be willing to transact with subsequent possessors of the currency. And so on.

Our willingness, at minimum, to use the fiat currency to cover our taxes is enough to ensure the government can transfer some labor services and real resources from the private to public sector.

In practice, of course, we are happy to use the national currency more widely than is needed merely to pay taxes. Not only do we mostly transact in the government’s unit of account but many of us also desire to save in it. The national currency is a secure form of saving provided it remains viable. And it remains viable so long as the government effectively enforces taxes and avoids issuing too much of its money.

This raises the question, how much currency issuance is “too much”?

When a unit of the currency – say a dollar – is issued, it will “circulate”, switching from hand to hand in various transactions until one of two things happens:

  • The dollar is used to pay tax
  • The dollar is saved.

In either case, the dollar is taken out of circulation. In the case of tax payments, the effect is permanent. The dollar is removed from the economy. In the case of saving, the effect can be temporary. If the saver chooses to spend the dollar at a later time, the dollar will re-enter circulation at that moment.

Whenever a dollar is withdrawn from circulation, it does not add to demand for goods and services, and so does not entice additional production nor put pressure on prices.

The implication for management of the currency depends on the state of the economy:

  • When the economy is at full employment and operating at full capacity, it is problematic for the government to issue still more currency without also increasing taxes. Otherwise, there will be excess demand and an inflationary episode.
  • When, instead, there is unemployment and excess capacity, there is room for additional non-inflationary currency issuance. Under these circumstances, extra demand for goods and services will chiefly encourage an expansion of production rather than price hikes as firms compete for the extra business.