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The Gresham's Law

Posted: Saturday, 25 October, 2014. | By: Kunta Siddhartha Kumar

Gresham's law signifies the economic principle that when a government overvalues one type of money (bad money) and undervalues another type of money (good money), there exists a natural phenomenon that the good money is driven out of the country's circulation. In simple terms, this can be said that when good and bad money circulate together as a legal tender, bad money drives good money out of the circulation. Let us discuss good money and bad money with the following example.

Example:
Consider an economy in which the government initially uses 100% gold coins (type-A) as a legal tender. Let us suppose that the government decides to introduce coins with 90% gold and 10% silver (type-B) as a medium of transaction. Since both the types of coins correspond to same denomination, it is expected that the circulation of both the types is equal in the economy. But, according to Gresham's law, assuming there is no shortage in circulation of both types of coins; individuals try to gain from type-A coins by melting them and procuring type B coins, which are of similar monetary value. Here, by melting 9 type-A coins, an individual can exchange for 10 type-B coins, which pay him the same monetary value. Here the pure gold coins (good money) eventually is taken away from circulation by the introduction of impure gold coins (bad money)

Similarly, if both paper money and metallic money are in circulation for same monetary value, metallic money disappears from the circulation system due to its high intrinsic value.

Historical significance:
The law is named after Sir Thomas Gresham, the financial agent of Queen Elizabeth 1, in the 16th century. To increase the government's income without raising taxes, Henry VII, the father of Queen Elizabeth introduced coins with 40% lesser silver than the original 100% silver coins. The English merchants were observed to save the pure silver shillings with them because of their higher intrinsic value and the whole market used the lesser valued coins as a medium of exchange. This situation of "bad money driving out good money" was explained to Queen Elizabeth 1 by Sir Thomas Gresham, triggering the British economist Henry Dunning Macleod use the word “Gresham's law" for the first time in 1858 to explain this theory.

Asymmetric information and Gresham’s law:
Consider the previous example of coin A and coin B. When there is no visible difference between the two coins, exchanging one coin for the other provides no incentive to either parties, given the information about the intrinsic values is uniform. But if one of the parties know the intrinsic value of the coin he is trading, it provides an incentive for him and loss for the other. This asymmetric information about the intrinsic values gave rise to Billonnage, where in, money experts, who are aware of the intrinsic values of the money used to make profits by melting heavy coins and recoining them as light coins.

Food for thought:
You need to pay 100 rupees to the shopkeeper. You have a new 100 rupee note and an old one in your purse. Which note would you pay to the shopkeeper?

References and recommended readings:
http://www.clevelandfed.org/research/commentary/2005/1001.pdf
http://www.minneapolisfed.org/research/qr/qr1012.pdf
http://sundaramponnusamy.hubpages.com/hub/What-Does-Greshams-Law-State

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