Nearly all contemporary money systems are based on fiat money, which is modern currency that has value only by government order.
Describe the different types of mediums used as currency
Fiat money is money that derives its value from government regulation or law. Value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity (such as gold).
Commodity money value comes from the commodity out of which it is made. The commodity itself constitutes the money, and the money is the commodity. For example gold, silver, copper, rice, salt, alcohol, and cigarettes are commodities that have been used as a medium of exchange.
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid-20th century. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states.
Fiat money originated in 11th century China, and its use became widespread during the Yuan and Ming dynasties. The Nixon Shock of 1971 ended the direct convertibility of the United States dollar to gold. Since then all reserve currencies have been fiat currencies, including the U.S. dollar and the euro.
Currency refers to physical objects generally accepted as a medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply. The other part of a nation's money supply consists of bank deposits (sometimes called deposit money), ownership of which can be transferred by means of checks, debit cards, or other forms of money transfer. Deposit money and currency are money in the sense that both are acceptable as a means of payment.
Money in the form of currency has predominated throughout most of history. Usually (gold or silver) coins of intrinsic value (commodity money) have been the norm. However, nearly all contemporary money systems are based on fiat money. In other words, modern currency has value only by government order (fiat). Usually, the government declares the fiat currency (typically notes and coins issued by the central bank) to be legal tender, making it unlawful to not accept the fiat currency as a means of repayment for all debts, both public and private.
Fiat money is money that derives its value from government regulation or law. Value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity (such as gold). The term fiat currency is also used when the fiat money is used as the main currency of the country. Some bullion coins such as the Australian Gold Nugget and American Eagle are legal tender, but they trade based on the marketprice of the metal content as a commodity, rather than their legal tender face value (which is usually only a small fraction of their bullion value).
Fiat money, if physically represented in the form of currency (paper or coins), can be accidentally damaged or destroyed . However, fiat money has an advantage over representative or commodity money in that the same laws that created the money can also define rules for its replacement in case of damage or destruction. For example, the U.S. government will replace mutilated Federal Reserve notes (U.S. fiat money) if at least half of the physical note can be reconstructed, or if it can be otherwise proven to have been destroyed. By contrast, commodity money which has been lost or destroyed cannot be recovered.
Currently, most modern monetary systems are based on fiat money. However, for most of history, almost all money was commodity money, such as gold and silver coins. As economies developed, commodity money was eventually replaced by representative money, such as the gold standard, as traders found the physical transportation of gold and silver burdensome. Fiat currencies gradually took over in the last hundred years, especially since the breakup of the Bretton Woods system in the early 1970s.
Many items have been used as commodity money such as naturally scarce precious metals, conch shells, barley, and beads, as well as many other things that are thought of as having value. Commodity money value comes from the commodity out of which it is made. The commodity itself constitutes the money, and the money is the commodity. Examples of commodities that have been used as mediums of exchange include gold, silver, copper, rice, salt, peppercorns, large stones, decorated belts, shells, alcohol, cigarettes, cannabis, and candy. The use of commodity money is similar to barter, but a commodity money provides a simple and automatic unit of account for the commodity which is being used as money.
Commercial Bank Money
Commercial bank money or demand deposits are claims against financial institutions that can be used for the purchase of goods and services. A demand deposit account is an account from which funds can be withdrawn at any time by check or cash withdrawal without giving the bank or financial institution any prior notice. Banks have the legal obligation to return funds held in demand deposits immediately upon demand (or "at call"). Demand deposit withdrawals can be performed in person, via checks or bank drafts, using automatic teller machines (ATMs), or through online banking.
Commercial bank money is created through fractional-reserve banking, which is the banking practice where banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets). Banks then lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand. Commercial bank money differs from commodity and fiat money in two ways. First, it is non-physical, as its existence is only reflected in the account ledgers of banks and other financial institutions. Second, there is some element of risk that the claim will not be fulfilled if the financial institution becomes insolvent.