Gresham’s Law

Updated on January 29, 2024
Article byAswathi Jayachandran
Reviewed byDheeraj Vaidya, CFA, FRM

What is Gresham’s Law?

Gresham’s law is an economic principle that states “bad money drives out good money.” In other words, money with the least valuable commodity form will circulate more among those with a similar face value in circulation. It generally refers to money made of worn coins and fresh coins.

Gresham’s law can influence government intervention in currency circulation. When agents are free to pick their medium of exchange in high-inflation countries, the low-inflation currency tends to displace the low-inflation currency. It can also influence the decisions of bankers and regulators. One can apply the law to monetary policiesMonetary PoliciesMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more and stock market investments.

Key Takeaways

  • Gresham’s law states that when two similar values of money are exchanged, and one is considered less valuable, the bad money will drop the good money from circulation.
  • It can work only when “good” and “bad” money in the economy exist at the same time.
  • The law becomes incapable when the nation rejects a currency and when the overall volume (good plus bad) of currency is insufficient.
  • Gresham’s law has very limited applications in the modern world where the paper money system is more prevalent.

Gresham’s Law Explained

Gresham's Law

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Gresham’s law states that “the bad currency drives out the good,” which relates to a time when the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more made all transactions with coins. It is associated with Sir Thomas Gresham, an English financier who lived in the time of Tudor dynasty.

Suppose an item worth an individual could buy $1 with two types of coins with the same value of $1. One comprises of gold, and the other comprises of silver. It is natural for the population to transact with the silver coin and save the gold for themselves as they are higher in value than silver. As a result, the poorer transaction medium would be used for most transactions, while the superior would play a minimal role.

An important point to note here is that Gresham’s law in economics applies when “good” and “bad” money exists simultaneously. Money that is “good” has little difference between its face value and its commodity value, such as the intrinsic value of the manufacturing metal. “Bad” money, on the other hand, is money that has a commodity value significantly lower than its face value yet can be a legal tender. In short, Gresham’s Law of money conveys that if there is no control over the supply of inferior currency’s supply, it will drive out the superior currency.

Recent times have reduced the legal connection between currency and precious metals. It has become much weaker and, in many cases, people have abandoned it entirely. In economies around the world, there exists a persistent trend of inflation. HyperinflationHyperinflationHyperinflation is merely an accelerated level of inflation that tends to quickly destroy the actual value of the local currency since there is a rise in the cost of all products and services, and it causes people to lower their holdings in that particular currency as they opt to participate in foreign currencies that are relatively more stable.read more can reach a point where money is no longer worth the paper it is printed on in extreme circumstances. When hyperinflation arises, foreign currencies typically replace local currencies, an example of Gresham’s law functioning in reverse. Even if legislative controls are in place, when a currency loses value quickly, people will abandon it in favor of more stable foreign currencies.

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Example

Take a look at an example where Gresham’s Law comes true and how the general population acts in the case of a valuable commodity.

When the Coinage Act of 1965 was established in the U.S., there was wide circulation of silver coins in Canada and the United States. These governments debased their currencies by moving to less expensive metals (such as nickel and copper). It resulted in inflation of the new devalued currencyDevalued CurrencyCurrency devaluation is deliberately done in order to adjust the established exchange rates by the government and it is mostly done in the cases of fixed currencies. This mechanism is used by economies with a semi-fixed or fixed exchange rate, and it should not be confused with depreciation.read more in comparison to the supply of the last silver coins. Citizens kept silver coins for investment value and to capture the stable current and foreseeable future value of the metal over the freshly inflated and devalued currencies, using the fresher coins for day-to-day transactions. To counter it, silver was taken out of circulation in U.S. dimes and quarter-dollar coins. It also reduced the silver content in the half dollar from 90% to 40%; the 1970 law later removed silver from the half dollar.

Limitations

Gresham’s law of money has a very limited scope of application in present times, when paper is the universal medium of money. The “good money” in coins can be melted, bagged to foreign lands, and sold by volume under a metallic standard. This is impossible to achieve with paper money or secondary coins. As a result, the law finds itself less important under a paper-money system.

The law is particularly inapplicable in the following situations:

  • When the overall volume of currency (good and bad money combined) is less than what the community requires as a medium of exchange, both good and bad money will circulate in such a situation irrespective of the differences in value.
  • When the “bad money” is low in value, people refuse to accept it. As a result, bad money will not circulate and will not be able to extinguish good money.

Frequently Asked Questions (FAQs)

What is Gresham’s Law?

Gresham’s law states that the value considered bad money (regarding a currency) will wipe out the good money. Bad money refers to the least valuable type of commodity money in circulation among those with equivalent face values. However, it is not much relevant in the use of paper money.

What is Gresham’s Law related to?

Gresham’s law is related to the money supply concept in the economy. It has a wide range of applications. It finds itself useful in fields like monetary policies and tacking inflation. The situation prevailing will help banks and other financial institutions in decision-making. 

What is a modern example of Gresham’s Law?

Gresham’s law is true in that the circumstances nudge the use of lesser value currency amongst the face value. Moreover, it will be true irrespective of the period it happens. For example, the U.S. replaced silver coins in the latter part of the 90’s due to people hoarding.

This has been a guide to what is Gresham’s law and its definition. We discuss the example and limitations of Gresham’s law along with detail explanation. You can learn more about it from the following articles – 

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