Legal Tender: Definition, Economic Functions, Examples

What Is Legal Tender?

Legal tender is anything recognized by law as a means to settle a public or private debt or meet a financial obligation, including tax payments, contracts, and legal fines or damages. The national currency is legal tender in practically every country. A creditor is legally obligated to accept legal tender toward repayment of a debt.

Understanding Legal Tender

Legal tender is established by a statute that specifies the thing to be used as legal tender and the institution that is authorized to produce and issue it to the public, such as the U.S. Treasury in the United States and the Royal Canadian Mint in Canada.

In the U.S., the recognized legal tender consists of Federal Reserve notes and coins. Creditors are required to accept them as payment offered to discharge a debt; however, except where prohibited by state law, private businesses may refuse to accept some or all forms of cash tender provided that a transaction has not already occurred and debt has not been incurred by the customer.

By default (and design), legal tender laws prevent the widespread adoption of anything other than the existing legal tender as money in the economy. A check, or a credit swipe, is not legal tender; it functions as a money substitute and merely represents a means by which the holder of the check can eventually receive legal tender for the debt.

Cryptocurrencies are not generally accepted for use as money largely because they lack legal tender status. However, El Salvador became the first country in the world to accept bitcoin as legal tender in June 2021.

In May 2013, the governor of Arizona vetoed a bill that would have made gold and silver coins legal tender in the state, in addition to existing U.S. currency.

Special Considerations

Some currencies, such as the U.S. dollar and euro, are used as legal tender in countries that either does not issue currencies of their own or have found the stable dollar preferable to their own currency. For example, Ecuador adopted the U.S. dollar as legal tender in 2000 after the Ecuadorian-issued currency, the sucre, depreciated rapidly such that $1 was worth 25,000 sucres.

In general, a legal tender can be in two fundamental forms. A government can simply ratify market-determined commodity money, such as gold, to be legal tender and agree to accept tax payments and enforce contracts denominated in that commodity. Alternatively, a government can declare an adulterated commodity or valueless token to be legal tender, which then takes on the characteristics of a fiat currency.

Economic Function of Legal Tender

Legal tender serves several purposes. By default, it is used by market participants to fulfill the functions of money in the economy: a medium of indirect exchange, a unit of account, a store of value, and a standard of deferred payment.

Proponents of legal tender laws argue that markets generally fail to produce the optimal type, quality, and quantity of money and that legal tender enhances the usefulness of money as a means to reduce transaction costs. Specifically, having a legal tender can allow flexibility in the money supply and a single currency can eliminate the transaction costs associated with the use of multiple competing currencies. The imposition of legal tender is one way to achieve a single currency.

The legal tender also makes monetary policy possible. From the point of view of the issuer, legal tender allows the manipulation, debasement, and devaluation of the currency by the issuer to obtain seigniorage and facilitates the issuance of fiduciary media by the banking system to meet the needs of trade.

In the absence of legal tender laws, Gresham's Law would make monetary policy, seigniorage, currency manipulation, and fiduciary media issuance much more difficult as good money tends to drive out bad money in that case.

Cryptocurrency and Legal Tender

The popularity of cross-border and online shopping is increasing the demand for more forms of money, such as popular cryptocurrency alternatives like bitcoin, to be recognized as legal tender. However, given official objection to such alternatives except in a few minor cases, these may still be some years away, and they do not represent legal tender in the U.S. or most other countries.

Many online services accept cryptocurrencies, and this practice is perfectly legal. Due to their status as unofficial competitors to legal tender, cryptocurrencies are mostly limited to use in gray and black market activity or as speculative investments.

However, there are a few exceptions. In 2018, facing devastating hyperinflation, Venezuelan President Nicolas Madura ordered all federal institutions to accept a new electronic currency, the petro, as legal tender.

The Venezuelan petro is controlled centrally by the Venezuelan government, based on their own estimation of the value of their natural resources. The petro was claimed to be backed by Venezuela's natural gas, mineral, and oil reserves. Venezuela's experiment with the petro has not made much progress, however, and the petro does not circulate generally as money despite its legal tender status.

The tiny Republic of the Marshall Islands (RMI) also announced that it would adopt a new cryptocurrency, the sovereign, as legal tender. The sovereign will be pegged to an existing, decentralized peer-to-peer cryptocurrency market. Currently, the U.S. dollar functions as money and legal tender in the RMI and will continue to do so alongside the new legal tender when the government begins issuing sovereigns.