Gresham’S Law

Published Oct 25, 2023

Definition of Gresham’s Law

Gresham’s Law states that “bad money drives out good money.” In other words, when multiple forms of currency are in circulation, the inferior and debased form of money tends to be preferred and used, while the superior and more valuable form of money is hoarded and removed from circulation. This phenomenon occurs due to the perception that the inferior money will be accepted at a higher value than its true worth, leading to a loss of purchasing power.

Example

To understand Gresham’s Law, let’s consider an example with two types of currency: gold coins and debased silver coins. Initially, both gold and silver coins are in circulation and are considered legal tender.

As the government starts debasing the silver coins by reducing their silver content, the intrinsic value of these silver coins decreases. However, their face value remains unchanged, leading people to perceive them as less valuable. At the same time, gold coins retain their full gold content and are therefore more valuable.

People begin to notice the difference in value between the two types of coins. They realize that they can use the debased silver coins to pay for goods and services at their face value, even though their true worth is lower. As a result, people start hoarding the gold coins and using the debased silver coins for transactions.

This hoarding of gold coins and increased circulation of debased silver coins is a perfect illustration of Gresham’s Law in action.

Why Gresham’s Law Matters

Understanding Gresham’s Law is crucial in the context of monetary policy and the stability of currency. When inferior forms of money consistently drive out superior forms, it can lead to various economic problems.

For instance, if people hoard gold coins and keep them out of circulation, it limits the money supply in the economy. This reduction in circulating currency can lead to deflationary pressures and hinder economic growth.

Moreover, Gresham’s Law highlights the importance of maintaining the integrity and stability of a currency. If a government consistently debases its currency, people will lose trust in it as a medium of exchange, resulting in economic instability and a loss of confidence in the overall financial system.