Why is it in the news?
- Gresham’s law was observed during Sri Lanka’s economic crisis when the central bank fixed the exchange rate between the Sri Lankan rupee and the U.S. dollar, causing the U.S. dollar to be undervalued and driven out of the formal foreign exchange market.
- The term “Gresham’s law” is named after English financier Thomas Gresham, who advised the English monarchy on financial matters.
- It applies to various forms of money, not just paper currency.
Understanding Gresham’s law
- Gresham’s law states that “bad money drives out good,” primarily occurring when a government fixes the exchange rate between two currencies at a ratio different from the market exchange rate.
- This price fixing leads to the undervalued currency (fixed below market rate) going out of circulation, while the overvalued currency remains but struggles to find buyers.
- Market exchange rates represent an equilibrium where currency supply equals demand.
- Supply increases as price rises and falls as price falls, while demand falls as price rises and rises as price falls.
- Government-fixed prices below market rates result in a currency shortage as demand surpasses supply.
- Gresham’s law comes into play when governments arbitrarily fix the exchange rate of commodity money (e.g., gold or silver coins) below the market price of the commodity, causing it to disappear from formal markets.
- Gresham’s law applies when governments legally fix exchange rates and effectively enforce those laws.
- In the absence of government-mandated exchange rates, “good money drives out bad,” known as Thiers’ law, where people choose to use better-quality currencies over poorer-quality ones.
- The rise of private cryptocurrencies is seen as an example of “good money” issued by private entities displacing government-issued “bad money.”