Legal Tender: Definition, Economic Functions, and Examples

What Is Legal Tender?

Legal tender is anything that's recognized by law as a means to settle a public or private debt or meet a financial obligation. This includes tax payments, contracts, and legal fines or damages. The national currency is legal tender in virtually 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 what's to be used as money and the institution that's authorized to produce it and issue it to the public. This would be the U.S. Treasury in the United States and the Royal Canadian Mint in Canada.

The recognized legal tender in the U.S. consists of Federal Reserve notes and coins. Creditors are required to accept them as payment when they're offered to discharge a debt. Private businesses may refuse to accept some or all forms of cash tender, however, if a transaction hasn't already occurred and debt hasn't been incurred by the customer, except where this is prohibited by state law.

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 generally aren't accepted for use as money largely because they lack legal tender status. El Salvador became the first country in the world to accept Bitcoin as legal tender in June 2021. The governor of Arizona vetoed a bill in May 2013 that would have made gold and silver coins legal tender in the state in addition to existing U.S. currency.

Adoptions of the U.S. Dollar

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

Forms of Legal Tender

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

Economic Function of Legal Tender

Legal tender serves several purposes. It's used by market participants to fulfill the functions of money in the economy as 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. They say that legal tender enhances the usefulness of money as a means to reduce transaction costs. Having a legal tender can allow flexibility in 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.

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

Gresham's Law would make monetary policy, seigniorage, currency manipulation, and fiduciary media issuance much more difficult in the absence of legal tender laws because good money tends to drive out bad money in this 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. Given official objection to such alternatives except in most cases, however, these may still be some years away. They don't represent legal tender in the U.S. or most other countries.

Many online services accept cryptocurrencies and this practice is perfectly legal. Cryptocurrencies are mostly limited to use in gray and black market activity or as speculative investments, however, due to their status as unofficial competitors to legal tender. There are a few exceptions, however. Venezuelan President Nicolas Madura ordered all federal institutions to accept a new electronic currency, the petro, as legal tender in 2018 when facing devastating hyperinflation.

The Venezuelan petro is controlled centrally by the Venezuelan government based on their 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 hasn't made much progress, however, and the petro doesn't circulate generally as money despite its legal tender status.

The tiny Republic of the Marshall Islands (RMI) adopted a new cryptocurrency, the sovereign (SOV), as legal tender. The sovereign is pegged to an existing, decentralized peer-to-peer cryptocurrency market. The U.S. dollar still functions as money and legal tender in the RMI, however, and it continues to do so along with the new legal tender.

The Bottom Line

Legal tender is the money or money equivalent that a country recognizes within its borders. It’s the nation’s currency in most cases. Other forms and sources of money aren’t recognized and can’t be accepted for payment.

This doesn’t rule out credit card payments or paper checks in the U.S. because they're based on American dollars but merchants and financial entities within the United States can’t accept pesos or cryptocurrencies for payment.