Definition
Gresham’s Law is a monetary principle stating that “bad money drives out good.” In a system where both “bad” money (coins that are clipped or otherwise reduced in their commodity value) and “good” money (coins of high commodity value) are accepted as equal legal tender, the “good” money tends to be hoarded or exported while the “bad” money remains in circulation. Ultimately, the currency’s overall value can decline because of this trend.
Phonetic
Gresham’s Law in phonetics would be represented as: ˈgrɛʃəmz lɔː
Key Takeaways
- Gresham’s Law Description: Gresham’s Law is a monetary principle stating that “bad money drives out good.” This means that if two types of money are in circulation and one is seen as more valuable or ‘good’ , people will hoard it and use the ‘bad’ money in regular trade. At a macro level, this illustrates how people prefer to exchange with currency that they believe has less intrinsic value.
- Importance in Economics: Gresham’s Law plays a significant role in economics, particularly in the monetarist and sub-monetarist thinking. Understanding Gresham’s principle can help lawmakers and economists make informed decisions about monetary policies, exchange rates, and the potential impacts of devaluing currency. As a result, Gresham’s Law is crucial for understanding and managing economic systems.
- Applications and Examples: An example of Gresham’s Law in action was when the U.S went off the gold standard during the 20th century. People started hoarding gold coins and using paper money instead, because they viewed gold as ‘good money.’ Gresham’s Law also applies to other sectors, beyond economy, such as data quality where ‘bad’ (poor quality) data can overwhelm ‘good’ (accurate) data, misleading decisions.
Importance
Gresham’s Law is a fundamental concept in economics and finance that states ‘bad money drives out good.’ It’s important because it provides insight into the impact of monetary policy and currency valuation. This law suggests that if two forms of currency are in circulation and one is perceived as being of lesser value, or ‘bad,’ individuals will hoard the ‘good’ money and use the ‘bad’ money for transactions. This behavior can potentially lead to serious economic consequences such as inflation, devaluation, and lack of trust in the financial system. It’s crucial for monetary authorities to take this law into account when designing and implementing policies to guard against these potential disruptions.
Explanation
Gresham’s Law is a key concept in monetary economics that has significant implications on the circulation and valuation of currencies. Its primary purpose is to demonstrate the effect that bad money has over good money in an economy. Essentially, it suggests that when two forms of currency are in circulation and one is perceived as being less valuable or “inferior” (bad money), then the more valuable or “superior” currency (good money) will gradually be hidden away or hoarded by people. The more common usage of such less valuable currency actually drives out the circulation of the more valuable one – hence the law is popularly stated as ‘bad money drives out good’.The use of Gresham’s Law is quite prevalent in developing economic theories or predicting currency behavior. Economists and policymakers often reference Gresham’s Law when analyzing phenomena like hyperinflation, currency debasement, or the potential effects of introducing a new currency. They may also use it to understand the dynamics involved if a country were on a bimetallic standard, wherein two metals are officially assigned value as legal tender. So, while Gresham’s Law might seem like a simple observation about currency, it serves as a powerful analytical tool in understanding complex economic systems and how different forms of money interact with each other.
Examples
1. Coinage Devaluation: The most common example of Gresham’s Law is its basis in 16th century coinage. During that time, many nations had both gold and silver coins in circulation. The law was used to explain how bad money (coins made of less valuable, or debased, metals) would be circulated more frequently because people would hoard the good money (coins made of more valuable metals).2. Hyperinflation in Zimbabwe: A notable recent instance of Gresham’s Law can be seen in the hyperinflation that took place in Zimbabwe in the late 2000s. The government was printing Zimbabwean dollars at an alarming rate and as the value of those dollars plummeted, people began to hoard foreign currencies that held more value. Thus, the “bad money” (Zimbabwean dollars) drove out the “good money” (currencies like the U.S. dollar, British pound etc.)3. Argentina’s Economic Crisis: During Argentina’s economic crisis in the late 20th century, the country suffered from severe inflation. The Argentine peso’s value decreased drastically, leading citizens to predominantly use U.S. dollars for transactions, effectively sidelining the peso. In this case, the bad money (Argentine peso) was driven out by the good money (U.S. dollar), aligning perfectly with Gresham’s Law.
Frequently Asked Questions(FAQ)
What is Gresham’s Law?
Gresham’s Law is a monetary principle stating that bad money drives out good. It means that if two forms of commodity money are in circulation, and both are accepted by law as having similar face value, the more valuable commodity will disappear from circulation.
Who coined Gresham’s Law?
Gresham’s Law was named after Sir Thomas Gresham, a 16th-century financial agent of Queen Elizabeth I. However, the concept pre-dates Gresham and was described by earlier scholars and economists.
Can you elaborate on the term bad money drives out good?
When people have two kinds of money of equal value by law, but one is inherently more valuable due to its content, people will hoard the more valuable money and spend the less valuable. In other words, cheaper or ‘bad’ money will be circulated while the valuable or ‘good’ money will be kept out of circulation, hence ‘bad money drives out good.’
Is Gresham’s Law applicable only to coinage or commodities?
No, although Gresham’s Law was named in an era when coins were the main form of money, the principle is more broadly applicable. It can also apply in a modern economy, for instance, when there’s a lack of confidence in a certain type of currency or financial assets.
Can Gresham’s Law also apply between two different national currencies?
Yes, it certainly can. For example, if a country with a weak and unstable currency is doing significant trade with a country with a strong, stable currency, people may prefer to hold onto the stronger currency and spend the weaker one.
What significance does Gresham’s Law hold in today’s economy?
Gresham’s Law can guide monetary policies and economic understanding in modern society. It can aid governments in understanding the implied effects of their monetary regulations, decisions on the valuation of their national currency, or even on the introduction of new forms of money, such as digital currencies.
Related Finance Terms
- Commodity Money
- Fiat Currency
- Market Exchange Rates
- Legal Tender
- Monetary Devaluation
Sources for More Information
