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Gresham’s Law

Facts for Prelims (FFP)

  

Source: TH

 Gresham’s Law, named after Thomas Gresham, states that “bad money drives out good” when the government fixes the exchange rate between two currencies at a level different from the market rate.

Impact:

  • This leads to the undervalued currency going out of circulation, while the overvalued currency remains but lacks buyers.
  • The law can result in a currency shortage when demand exceeds supply due to the fixed price.

Gresham’s law applies not only to paper currencies but also to commodities. It can cause goods to disappear from the formal market when their prices are forcibly undervalued by governments.

 

Explanation using example:

Imagine a country where both gold coins and copper coins are used as currency. The government sets an exchange rate, saying that 10 copper coins are equal in value to 1 gold coin, even though the market values them differently.

In this scenario, people will start hoarding and using gold coins because they are more valuable. They will spend copper coins, which are considered “bad money,” in everyday transactions, keeping the “good money” (gold coins) for themselves.

Eventually, the circulation of copper coins increases, while gold coins become scarce in daily transactions. This demonstrates Gresham’s Law in action, where the undervalued (copper) currency pushes out the more valuable (gold) currency from everyday use.

 

The alternative:

Thiers’ law, on the other hand, states that “good money drives out bad” when people have the freedom to choose between currencies, and they prefer higher-quality currencies.