Gresham’s law

3 key takeaways:

• Bad money drives out good: When both good and bad money are in circulation, people tend to spend the less valuable money and hoard the more valuable one.
• Historical context: Gresham’s Law was first articulated in the context of bimetallism, where coins made of different metals circulated together.
• Economic implications: The law explains why currencies that are debased or devalued tend to remain in circulation while more valuable currencies disappear from everyday use.

What is Gresham’s Law?

Gresham’s Law is named after Sir Thomas Gresham, an English financier who articulated the principle in the 16th century. The law is based on the observation that when two types of money with the same nominal value are in circulation, but one type has a higher intrinsic value than the other, people will tend to use the less valuable money for transactions and hoard the more valuable money. This phenomenon occurs because rational economic agents prefer to keep money that has higher intrinsic value (good money) and spend money that has lower intrinsic value (bad money).

How Does Gresham’s Law Work?

1. Dual Currency Circulation: Gresham’s Law typically applies in situations where two types of currency are circulating simultaneously. This can occur with bimetallic standards, where gold and silver coins are used together, or with paper money and coinage that have different intrinsic values.
2. Hoarding Good Money: People recognize that one form of money has greater intrinsic value. For example, gold coins are more valuable than silver coins of the same face value. Consequently, they tend to hoard the more valuable gold coins.
3. Spending Bad Money: To make transactions, people spend the less valuable money. In the example above, silver coins are more likely to be spent while gold coins are kept out of circulation.
4. Resulting Circulation: Over time, the more valuable money disappears from circulation, either being hoarded or melted down for its intrinsic value, while the less valuable money remains in use.

Historical Examples of Gresham’s Law

Bimetallism

During periods of bimetallism, where both gold and silver coins were used, discrepancies in the intrinsic value of these metals often led to one type of coin being hoarded. For instance, if the market value of silver fell below its face value, people would hoard gold coins and spend silver coins.

Currency Debasement

In medieval and early modern Europe, kings and governments often debased their currency by reducing the precious metal content of coins. As a result, people hoarded the older, more valuable coins and spent the newer, debased ones, illustrating Gresham’s Law.

Modern Applications

In modern economies, Gresham’s Law can be seen when there are different forms of currency or payment methods with varying intrinsic or perceived value. For example, during periods of hyperinflation, people might spend devalued paper currency quickly while hoarding goods, foreign currency, or other stores of value.

Importance and Implications of Gresham’s Law

Understanding Currency Circulation

Gresham’s Law helps economists and policymakers understand how currency circulates and why certain types of money disappear from active use. It underscores the importance of maintaining stable and trustworthy currency systems.

Policy Formulation

The principle informs monetary policy, particularly in the context of managing bimetallic standards, preventing currency debasement, and ensuring that fiat money retains its value and public trust.

Behavioral Economics

Gresham’s Law illustrates how individuals make rational economic decisions based on the intrinsic value of money, contributing to the broader understanding of behavioral economics and monetary theory.

Challenges and Considerations

Changing Economic Contexts

Gresham’s Law is primarily historical and its direct application is less common in modern fiat money systems where the value of money is not based on intrinsic worth but on government backing and public trust.

Exceptions to the Law

There are scenarios where good money does not get hoarded. For example, if the legal tender laws enforce the use of both types of money, or if the government strictly controls the money supply, Gresham’s Law might not apply.

Evolution of Money

The evolution of digital currencies and electronic payments introduces new dynamics in currency circulation that Gresham’s Law might not fully encompass. Understanding these new forms requires adaptation of traditional economic principles.

Related Topics

To further understand Gresham’s Law, it is beneficial to explore related topics such as the history of money, monetary theory, bimetallism, fiat money, and currency debasement. Studying the principles of behavioral economics and rational choice theory can provide insights into the decision-making processes underlying Gresham’s Law. Additionally, examining modern monetary policies and the role of central banks can highlight the ways in which contemporary economics addresses the issues that Gresham’s Law identifies. Understanding the broader context of economic history and the development of monetary systems is crucial for comprehensively grasping the significance and implications of Gresham’s Law.