Fiat Currency & Central Banking
Lesson by Uvin Vindula
The word "fiat" comes from Latin, meaning "let it be done" — a decree or command. Fiat money is currency that has value because a government says it does, not because it is backed by a physical commodity like gold or silver. Every national currency in the world today — the US dollar, the euro, the Sri Lankan rupee, the Japanese yen — is fiat money. Understanding how fiat currency and central banking work is critical for understanding why Bitcoin was created.
How Fiat Money Works
Fiat money has no intrinsic value. A 5,000 LKR note is just paper and ink — the physical materials are worth a fraction of a rupee. Its value comes from three sources:
- Legal tender laws: The government decrees that this currency must be accepted for all debts, public and private. In Sri Lanka, the Monetary Law Act gives the Sri Lankan rupee its legal tender status.
- Tax obligations: Citizens must pay taxes in the national currency, creating guaranteed demand. You cannot pay Sri Lankan taxes in gold, Bitcoin, or US dollars — you need rupees.
- Network effects and trust: People accept rupees because they believe others will accept them in turn. This circular trust is powerful but fragile — when it breaks, as it did in Zimbabwe (2008), Venezuela (2018–present), or Lebanon (2020–present), the results are catastrophic.
Central Banks: The Money Managers
Every fiat currency has a central bank responsible for managing the money supply and monetary policy. In Sri Lanka, this is the Central Bank of Sri Lanka (CBSL), established in 1950. Other notable central banks include the US Federal Reserve (the Fed), the European Central Bank (ECB), and the Bank of Japan (BOJ).
Central banks have several key powers:
| Power | How It Works | Impact |
|---|---|---|
| Setting interest rates | Raising or lowering the cost of borrowing | Higher rates slow the economy and reduce inflation; lower rates stimulate borrowing and spending |
| Money creation | Creating new money (digitally, not by printing physical notes) | Increases money supply, which can cause inflation if supply outpaces economic growth |
| Reserve requirements | Dictating how much cash banks must hold vs. lend | Lower requirements allow more lending (money multiplication), higher requirements restrict it |
| Lender of last resort | Bailing out banks that face collapse | Prevents bank runs but creates moral hazard — banks take bigger risks knowing they'll be rescued |
Fractional Reserve Banking: How Banks Multiply Money
Most people believe that banks lend out money that depositors have saved. The reality is far more interesting — and alarming. Under fractional reserve banking, banks are required to keep only a fraction of deposits in reserve (often as low as 3-10%) and can lend out the rest. But the money they lend is created out of thin air — it doesn't come from existing savings.
Here's a simplified example:
- You deposit LKR 1,000,000 in a Sri Lankan bank.
- The bank keeps LKR 100,000 in reserve (10%) and lends LKR 900,000 to someone buying a vehicle.
- The vehicle seller deposits the LKR 900,000 in their bank, which keeps LKR 90,000 and lends LKR 810,000.
- This process repeats. Your original LKR 1,000,000 deposit can create up to LKR 10,000,000 in total money supply.
This money multiplier effect means that the vast majority of money in circulation — estimated at over 90% — was created by commercial banks through lending, not by central banks printing physical notes.
The CBSL and Sri Lanka's Monetary History
Sri Lanka's relationship with central banking offers a cautionary tale. The CBSL has faced several critical challenges:
- The 2022 economic crisis: Years of money printing to finance government deficits, combined with ill-advised tax cuts and the organic farming ban, led to a severe balance of payments crisis. Foreign reserves dropped to near zero, the rupee crashed from ~200 LKR/USD in early 2022 to over 360 LKR/USD, and the country defaulted on its foreign debt for the first time in history.
- Chronic inflation: Sri Lanka has experienced average annual inflation of 8-10% over the past several decades, meaning prices roughly double every 7-9 years. What cost LKR 100 in 2000 costs over LKR 500 in 2026.
- Political interference: Central bank independence has been repeatedly compromised by political pressure to keep rates low and finance government spending through money creation.
The Cantillon Effect: Who Benefits from New Money?
When new money is created, it doesn't reach everyone simultaneously. Those closest to the money source — banks, large corporations, government contractors — receive new money first and spend it at current prices. By the time the new money trickles down to ordinary workers and savers, prices have already risen. This is the Cantillon Effect, named after 18th-century economist Richard Cantillon.
This mechanism systematically transfers wealth from savers and wage earners to asset holders and those with first access to credit — a hidden tax that no legislature voted for and no citizen consented to.
Key Takeaways
- •Fiat money has value by government decree, legal tender laws, and tax obligations — not because it is backed by any commodity
- •Central banks like the CBSL manage monetary policy through interest rates, money creation, reserve requirements, and acting as lender of last resort
- •Fractional reserve banking allows banks to create money through lending — a LKR 1,000,000 deposit can generate up to LKR 10,000,000 in the broader money supply
- •Over 90% of money in circulation is created by commercial banks through lending, not by central banks printing physical notes
- •Sri Lanka's 2022 crisis demonstrated the dangers of excessive money printing, political interference in central banking, and loss of trust in fiat currency
- •The Cantillon Effect means new money benefits those closest to the source first, systematically transferring wealth from savers and workers to asset holders
Quick Quiz
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What gives fiat money its value?