Greshams law

What Is Gresham's Law?

Gresham's Law is an economic principle in monetary economics stating that "bad money drives out good money" when both are required to be accepted at the same face value under legal tender laws. This means that if two forms of currency are in circulation and one has a higher intrinsic value than the other, people will tend to spend the "bad" (less valuable) money and hoard the "good" (more valuable) money. Over time, the more valuable currency disappears from active circulation. Gresham's Law highlights the behavioral tendency of individuals to retain assets they perceive as more valuable, while expending those deemed less valuable.

History and Origin

The observation behind Gresham's Law dates back to ancient times, with references found in Aristophanes' play The Frogs and in medieval writings³⁷, ³⁸. The principle is named after Sir Thomas Gresham (1519–1579), an English financier who served Queen Elizabeth I. In 1558, Gresham explained to the Queen that the "unexampled state of badness" of England's coinage, a result of the "Great Debasements" under Henry VIII and Edward VI, had led to the disappearance of gold from the realm. ³⁵, ³⁶During these periods, the metallic content of English silver coins was reduced, making the new coins less valuable intrinsically than the older, purer ones, despite both being accepted at the same nominal value.
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The Scottish economist Henry Dunning Macleod officially attributed the term "Gresham's Law" to Sir Thomas Gresham in 1858. ³³While Gresham was not the first to note this phenomenon, his clear elucidation of it brought it to prominent attention.
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Key Takeaways

• Gresham's Law states that "bad money drives out good money" when both circulate at the same legal value.
• This typically occurs when different forms of money have varying intrinsic values but are mandated by law to be accepted at par.
• Individuals will prefer to spend the money with lower intrinsic value and hoard the money with higher intrinsic value.
• The law primarily applies in contexts where legal tender laws prevent the market from differentiating between the "good" and "bad" money through price adjustments.
• Historically, this principle was evident in the debasement of coinage.

Interpreting Gresham's Law

Gresham's Law explains how certain government monetary policy decisions, particularly those related to fixed exchange rates or legal tender laws, can inadvertently distort the circulation of money. When a government assigns the same nominal value to different forms of currency that possess differing intrinsic values, rational economic agents will act to preserve their wealth. ³⁰They will use the "bad" money for transactions, as it costs them less in terms of real value, while saving or hoarding the "good" money, which retains higher market value or purchasing power.

For Gresham's Law to operate, a state of disequilibrium must exist where there is a divergence between the nominal (face) value and the intrinsic or commodity value of the circulating mediums. ²⁸, ²⁹If the "good" money were allowed to trade at a premium, or the "bad" money at a discount, the incentive to hoard would diminish, and both could circulate together, often indicating a different market dynamic.
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Hypothetical Example

Imagine a small island nation called "Coinland" where, for centuries, all transactions used silver coins. Each coin had a certain weight of pure silver, giving it its intrinsic value. One day, the government, facing financial difficulties, decides to introduce new silver coins that look identical but contain significantly less silver, effectively debasing the currency. However, the government declares that both the old, pure silver coins ("good money") and the new, debased coins ("bad money") must be accepted at the same face value for all debts and purchases.

As Coinland's citizens become aware of the difference, they begin to differentiate between the coins. When buying goods or paying taxes, they will invariably choose to spend the new, debased coins. They will consciously hold onto the older, purer silver coins, perhaps melting them down for their higher metallic content or saving them for future transactions where their true value might be recognized, such as international trade. Over time, the older, purer coins become increasingly rare in daily commerce, driven out by the less valuable, debased coins. This scenario illustrates Gresham's Law in action, where the "bad money" (debased coins) quickly displaces the "good money" (purer coins) from active circulation.

Practical Applications

Gresham's Law is primarily observed in historical monetary systems, particularly those based on commodity money like gold and silver coinage.

• Coin Debasement: Governments historically debased coinage by reducing the precious metal content while maintaining the same face value to increase revenue or finance wars. ²⁵This practice frequently led to the disappearance of the higher-purity coins from circulation.
• Post-1965 U.S. Coinage: A modern example in the United States occurred after the Coinage Act of 1965. This act reduced the silver content of U.S. half-dollars from 90% to 40% (and eliminated it entirely from dimes and quarters), and later removed all silver from the half-dollar in 1971. ²⁴Consequently, pre-1965 90% silver coins quickly disappeared from circulation as people hoarded them or melted them down for their silver content, while the newer, less valuable coins continued to circulate.
• Hyperinflation Scenarios: In extreme cases of inflation, such as Zimbabwe's hyperinflation in 2008, Gresham's Law can operate in reverse, with "good money" (more stable foreign currencies) driving out "bad money" (rapidly devaluing local fiat money) as people refuse to accept the local currency. ²², ²³This happens when legal tender laws can no longer be effectively enforced, allowing the market to choose preferred currencies.
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  The instability created by Gresham's Law was a significant factor in the historical debates surrounding monetary standards, particularly in the shift from bimetallism to the gold standard.
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Limitations and Criticisms

While Gresham's Law provides a powerful explanation for certain monetary phenomena, it has limitations and has faced criticisms regarding its broader applicability. The law is most strictly applicable when there are fixed legal exchange rates between different forms of money with differing intrinsic values. ¹⁸, ¹⁹In the absence of such compulsion or when transactions costs are high for using "good money" at a premium, the law's effects may be mitigated.
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Nobel laureate Robert Mundell rephrased Gresham's Law as "cheap money drives out dear money only if they must be exchanged for the same price". ¹⁴, ¹⁵This highlights that if the "good" money is allowed to command a premium in the market, it may not be driven out. For example, in situations where two currencies circulate but one is generally preferred, the preferred currency may still be used if its price adjusts accordingly. Modern economies, largely based on fiat currencies without intrinsic metallic value, experience the traditional form of Gresham's Law less frequently. ¹³However, analogous situations can arise in competitive markets where lower-quality goods or practices might drive out higher-quality ones if consumers cannot easily differentiate quality or if regulations distort market signals.
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Gresham's Law vs. Bimetallism

Gresham's Law is often discussed in the context of bimetallism, a monetary system where two metals (typically gold and silver) are used as legal tender at a fixed exchange rate set by the government. ¹¹The key distinction is that Gresham's Law describes the outcome or effect within such a system, rather than the system itself.

Under a bimetallic standard, if the government-mandated mint ratio between gold and silver coins differs from their prevailing market value ratio, one metal will become legally overvalued and the other undervalued. ¹⁰For example, if silver is overvalued relative to gold at the mint, people will tend to pay debts and conduct transactions with silver (the "bad" money) and hoard or export gold (the "good" money). ⁸, ⁹This results in the "good money" (gold) being driven out of circulation, effectively converting the bimetallic system into a de facto monometallic (silver) standard. The instability caused by Gresham's Law was a major reason many countries eventually abandoned bimetallism in favor of a single metallic standard, such as the gold standard, in the late 19th and early 20th centuries.
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FAQs

What does "bad money drives out good" mean?

It means that when two forms of money—one intrinsically more valuable ("good money") and one less valuable ("bad money")—are legally required to be accepted at the same price, people will spend the "bad money" and keep the "good money" for saving or other uses. This causes the "good money" to disappear from everyday transactions.

Is Gresham's Law still relevant today with fiat money?

In its traditional sense, Gresham's Law is less common with modern fiat currencies, which lack intrinsic value derived from a physical commodity. However, the underlying principle—that lower-quality options can displace higher-quality ones under certain conditions (e.g., price controls or information asymmetry)—can still be observed in various economic and even non-economic contexts.

How is inflation related to Gresham's Law?

In severe inflation or hyperinflation scenarios, people may try to get rid of rapidly devaluing local currency ("bad money") as quickly as possible, preferring to use or hoard more stable foreign currencies or assets ("good money"). In such ⁵, ⁶extreme cases, if people are free to choose, the "good money" might drive out the "bad money," which is sometimes referred to as a "reverse Gresham's Law".

Doe⁴s Gresham's Law apply to non-monetary situations?

While rooted in monetary theory, the core behavioral observation of Gresham's Law can be extended metaphorically to other areas. For instance, in an environment where low-quality products or services are indistinguishable in price or perceived value from high-quality ones, the lower-quality option might dominate the market as consumers opt for the cheaper alternative.

Wha³t is the role of legal tender laws in Gresham's Law?

Legal tender laws are crucial for Gresham's Law to operate in its classic form. These laws compel individuals to accept both "good" and "bad" money at the same nominal value, regardless of their differing intrinsic values. Without ²such legal compulsion, the "good money" might trade at a premium, or the "bad money" at a discount, allowing both to circulate based on their actual market value.¹