What Is Fiat Currency?
"Fiat" is a government issued currency that is not backed by a physical commodity such as gold or silver. Instead, it is back by the "good faith and credit" of the issuing government.
All modern government currencies are fiat, from yen to dollars.
Fiat currency has no utility in and of itself. It only has value because the government says it does and people accept it.
In other words, it really isn't backed by anything.
Since fiat currency has no connection to any commodity, it essentially floats. It's "value" relative to other currencies or commodities is based on supply and demand, along with the stability of the issuing government.
Sound money is limited by the supply of the commodity it is linked to. For instance, if a currency is backed by gold, the government can't create more unless it acquires more gold. This limits the issuance of new money. This minimizes inflation and keeps it relatively constrained and constant.
But since fiat isn't linked to any tangible thing, governments can create new money out of thin air without limits.
Economist Thorsten Polleit explained it this way.
"Fiat currencies are produced by central banks and commercial banks’ credit expansion. In fact, central banks in cahoots with commercial banks increase the outstanding money supply by extending loans to firms, private households, and government entities. It amounts to money creation from thin air or—in a way—counterfeiting money."
You can see the inflationary tendency when you compare the expansion of the gold supply to the expansion in the dollar supply.
The amount of mined gold has grown over the years, but it has expanded at an average annual rate of 1.2% over the last 529 years. Since 1960 the average growth in the gold stock is 1.8%, ranging from 1.4% to 2.2%.
Compare that to the stock of dollars. Since 1960, money supply growth varied from a low of 1% in 1993 to a high of 19.1% in 2020. This inconsistency in the rate of growth results in swings in the dollar stock that in turn causes volatility in prices. There are either not enough or too many dollars circulating relative to the prevailing level of economic activity.