Definition
Gresham’s Law is a monetary principle stating that “bad money drives out good.” In currency valuation, it means that if two forms of currency are in circulation, the one with higher intrinsic value will be hoarded and the one with lesser intrinsic value will be used for trading. It’s named after Sir Thomas Gresham, a 16th-century financial adviser to Queen Elizabeth I.
Key Takeaways
- Gresham’s Law states that “bad money drives out good”. In an economic framework, when both forms of money (devalued and not devalued) are considered equal by law, people tend to hoard the ‘good’ money (valuable) and circulate the ‘bad’ money (less valuable).
- The law was named after Sir Thomas Gresham, a 16th-century financial agent of Queen Elizabeth I. However, the concept has been recognized and discussed by scholars and economists for centuries even before Gresham’s time.
- Understanding Gresham’s law can illuminate economic and financial trends, especially in times of financial duress or when governments initiate policy changes affecting their currency. This also holds relevance to inflationary scenarios where people spend depreciating currency first and retain appreciating ones.
Importance
Gresham’s Law is a fundamental principle in the finance and economic field that posits “bad money drives out good.” This is important as it deals with the exchange and circulation of currency within a economy.
It suggests that if two forms of commodity money are in circulation, which are considered legal tender, the one with higher intrinsic value will be hoarded and the one with lesser intrinsic value will flood in circulation.
For example, if there are gold coins and copper coins in a market, people tend to accumulate and hoard the more valuable gold coins while spending the copper ones.
This can lead to economic balance disruption, inflation and even perturbation in trade flow.
Understanding this principle assists in making informed decisions in issues related to monetary policy and currency management.
Explanation
Gresham’s Law is a monetary principle stating that “bad money drives out good”. This principle is a key economic concept that is primarily used to explain the phenomena of currency circulation within an economy, specifically when two forms of commodity money are in active use concurrently. When a government overvalues one type of money and undervalues another, people will hoard the money that is undervalued and use the overvalued money for trade.
This leads to the scenario where the “bad” (overvalued) money circulates while the “good” (undervalued) money disappears from circulation, which is the main idea behind Gresham’s law. For example, if there are two forms of commodity money in circulation which are accepted by law as having similar face value, people will tend to hoard the money that they believe has a higher intrinsic value and spend the money that they perceive to be of lesser value.
The perceived “good” money will eventually be hoarded and effectively be driven out of circulation, leaving only the “bad” money in active circulation. Gresham’s Law, thus, serves as a compelling commentary on the negative impacts of government interference in the currency market by highlighting how it can inadvertently lead to an economy being dominated by a currency of lower intrinsic value.
Examples of Gresham’s Law
Gresham’s Law, named after Sir Thomas Gresham, states that “bad money drives out good.” This means that if two forms of currency are in circulation and one is perceived as lesser in value (bad money), people will hoard the more valuable currency (good money) and spend the lesser one. Here are three real world examples of this:
Hyperinflation in Zimbabwe: From 2007 to 2009, Zimbabwe experienced immense hyperinflation. The central bank was forced to keep printing money, leading to the circulation of banknotes with values of up to 100 trillion Zimbabwean dollars. The bills rapidly lost value due to hyperinflation, leading people to hoard stable foreign currencies such as the US dollar or the South African rand, while rushing to spend their Zimbabwean dollars. This widespread behavior eventually led the government to abandon its own currency in
Canadian $1 and $2 coins (“loonies” and “toonies”): When Canada introduced the $1 coin (“loonie”) in 1987 and the $2 coin (“toonie”) in 1996, they became the “good money”, perceived as being more valuable as they were new, shiny, and durable. People began to hoard these coins while spending the older, “bad” paper notes which were perceived as less valuable. Over time, the Canadian government had to remove the old paper bills from circulation as they were not being used anymore.
US Silver Coinage Disappearance: Prior to 1965, US quarters and dimes consisted of 90% silver. However, as the intrinsic value of the silver surpassed the coins’ face value, people began to hoard these coins for their silver content, resulting in a scarcity of quarters and dimes in the circulation. This eventually led the United States to switch coin content to cheaper metals.
FAQs on Gresham’s Law
1. What is Gresham’s Law?
Gresham’s Law is a monetary principle that states “bad money drives out good.” In an economy, if two forms of commodity money are in circulation, which are accepted by law as having similar face value, the more valuable commodity will gradually disappear.
2. Who introduced Gresham’s Law?
Gresham’s Law was named after Sir Thomas Gresham, a financial adviser to Queen Elizabeth I. But the concept has been recognized and applied since ancient times.
3. How does Gresham’s Law work?
According to Gresham’s Law, when a government overvalues one type of currency and undervalues another, people will start hoarding the undervalued money and using the overvalued money for transactions, effectively driving the former out of circulation.
4. What are examples of Gresham’s Law?
Historic examples of Gresham’s Law can be seen in the Roman empire when the government began to mint less valuable coins and people started hoarding and melting down the more valuable ones. Or during the US civil war, gold and silver coins were driven out of circulation by government-issued paper money.
5. Is Gresham’s Law applicable to today’s economy?
Yes, Gresham’s law still holds relevance today. Any situation where valued currency is exchanged at the same rate as less valued currency can result in the removal of more valued currency from the economy. However, today’s monetary systems are more complex and influenced by many factors other than the intrinsic value of the currency.
Related Entrepreneurship Terms
- Legal Tender
- Currency Devaluation
- Inflation
- Commodity Money
- Fiat Currency
Sources for More Information
- Investopedia: This trusted resource provides a wide range of financial information, including an entry on Gresham’s Law.
- Encyclopedia Britannica: As a reliable general encyclopedia, this resource offers well-researched articles on countless topics, including Gresham’s Law.
- Corporate Finance Institute (CFI): This professional resource provides in-depth information about various finance and economics topics, including Gresham’s Law.
- Economics Help: This resource provides a wealth of information on many economics and finance concepts and theories, including Gresham’s Law.
