Gresham’s Law is an economic principle asserting that “bad money drives out good money” in a currency circulation system where both types of money are used concurrently. This often occurs when there are differing intrinsic values in currencies that legally circulate with equivalent face values.
Definition and Formal Explanation
Gresham’s Law states that when coins with different metal contents (same face value but different intrinsic values) coexist in the economy, the lesser-valued ‘bad’ coins will circulate, while the higher-valued ‘good’ coins will be hoarded or removed from circulation.
Mathematical Representation: If \( C = C_{\text{good}} + C_{\text{bad}} \), where \( C \) is the total currency in circulation, \( C_{\text{good}} \) will tend to decrease, and \( C_{\text{bad}} \) will dominate.
Historical Context and Origin
The principle is named after Sir Thomas Gresham, an English financier in the 16th century. Although the concept was recognized earlier in history, it was Thomas Gresham who famously articulated it regarding the coinage practices in 1558.
Early Examples
- Ancient Greece: Debasement during the reign of Dionysius of Syracuse.
- Medieval England: Silver pennies replaced by less valuable coinage.
Modern Instances
- Zimbabwe Hyperinflation: The over-production of banknotes led to the disappearance of more stable foreign currencies.
How Gresham’s Law Manifests
Economic Impact
Low intrinsic value currency remaining in circulation can lead to lack of confidence in the monetary system, potentially resulting in inflation or currency devaluation.
Effects on Currency Markets
- Hoarding: High-value currency is stored and withdrawn from daily transactions.
- Black Market Development: Emergence of parallel currencies or barter systems as alternatives.
Comparisons and Related Concepts
Thiers’ Law
A converse principle where “good money drives out bad,” typically observed in bimetallic standards where the more valuable metal replaces the less valuable one in transactions.
Legal Tender Laws
Regulations that support the usage of a country’s currency as accepted payment for debts and obligations, influencing how Gresham’s Law plays out in different markets.
Fiat Money vs. Commodity Money
- Fiat Money: No intrinsic value, value is derived from government regulation.
- Commodity Money: Intrinsic value (e.g., gold coins), susceptible to Gresham’s Law consequences.
FAQs about Gresham’s Law
-
Q: Does Gresham’s Law still apply today with digital and fiat currencies?
- A: Yes, primarily seen in scenarios where countries with strong currencies face inflows and outflows of debased foreign currencies.
-
Q: How can Gresham’s Law be mitigated?
- A: Through robust legal tender laws and ensuring currency similarity in value and physical form.
Key References
- Rolnick, A. J., & Weber, W. E. (1997). Gresham’s Law or Gresham’s Fallacy? Journal of Political Economy.
- Selgin, G. (2003). Gresham’s Law. The New Palgrave Dictionary of Economics, 2nd Edition.
Summary
Gresham’s Law remains a fundamental principle in understanding currency dynamics and economic history. Its lessons are valuable in both historical analysis and modern monetary policy-making, illustrating how the nature of money circulating within an economy can evolve and impact financial stability.
