GRESHAM'S LAW

• Gresham’s law refers to the dictum that “bad money drives out good.” Gresham’s law
  comes into play when the exchange rate between two money or currencies is fixed by
  the government at a certain ratio that is different from the market exchange rate.
• Such price fixing causes the undervalued currency that is, the currency whose price is fixed at a level below the market rate to go out of circulation.
• The overvalued currency, on the other hand, remains in circulation but it does not find enough buyers.

3. The Dynamics of Exchange Rates

• The market exchange rate represents an equilibrium price where currency supply equals demand.
• Currency supply increases with rising prices and decreases with falling prices, while currency demand falls as prices rise and rises as prices fall.
• When a government fixes a currency's price below the market exchange rate, it disrupts this delicate balance, leading to adverse consequences.
• Price fixing by the government causes a decrease in the supply of the undervalued currency and an increase in its demand.
• Consequently, this intervention can trigger a currency shortage, where demand surpasses supply.
• The undervalued currency becomes scarce, prompting individuals to seek alternatives.

4. Origin of the Term

• Thomas Gresham, an English financier who advised the English monarchy on financial matters, lent his name to this principle.
• Gresham's law is not limited to paper currencies but extends to commodity currencies and various goods.
• Whenever a commodity's price, whether used as money or not, is artificially set below its market value, it tends to vanish from formal markets.
• Often, goods may even flow out of a country through black markets when they are undervalued by government actions.

5. Application to Commodity Money

• Gresham's law is readily observed when governments fix the exchange rate or price of commodity money, such as gold and silver coins, significantly below their market value.
• In such instances, holders of commodity money prefer not to offer it at the government-set price.
• Some may even choose to melt these coins to extract the pure gold and silver, which they can then sell at a higher market rate, circumventing the government's price controls.
• One example of Gresham's law is the debasement of the Roman currency in the 3rd century AD. The Roman government began to debase the currency by reducing the amount of silver in each coin.
• This led to the less valuable coins becoming more common in circulation, while the more valuable coins were hoarded or melted down.
• Another example of Gresham's law is the hyperinflation in Germany in the early 1920s.
• The German government printed so much money that the value of the currency plummeted.
• This led to people using the less valuable paper currency for everyday transactions and hoarding the more valuable gold and silver coins.

6. The Way Forward

• Gresham's law serves as a valuable insight into the dynamics of currency and commodity markets.
• It highlights the consequences of government intervention in fixing prices, underscoring the tendency for "bad money" (undervalued currency) to displace "good money" (currency reflecting market value).
• Understanding Gresham's law can provide valuable lessons for policymakers and individuals alike in navigating the complexities of monetary systems and exchange rates.