What is Gresham's Law?

Gresham's Law is named after Sir Thomas Gresham, an English financier in the 16th century. The principle states that "bad money drives out good money." To understand Gresham's Law, we first need to define two key terms: 1. Good money: This refers to currency with a higher intrinsic value, which often means that it has a higher precious metal content (e.g., gold, silver) compared to the face value of the currency. People usually prefer to save or hoard good money due to its higher intrinsic value. 2. Bad money: This refers to currency with a lower intrinsic value, usually because the precious metal content has been debased or the paper money is not adequately backed by reserves. People typically prefer to spend or exchange bad money instead of saving it since its value can decrease over time.

Gresham's Law is based on the observation that people will choose to spend the "bad money" in financial transactions and save the "good money" due to their differing intrinsic values. This means that bad money will circulate more in the economy, gradually replacing good money as it is hoarded or taken out of circulation. When you have both good money and bad money in circulation with equal legal tender status, people will try to spend the bad money first and keep the good money for themselves. This is known as "selective exchange," and it leads to the bad money driving out the good money from circulation.

Now that we have explained the mechanism behind Gresham's Law, let's look at some examples from history: 1. Roman Empire: As the Roman Empire faced economic issues, the government began debasing the silver content in their coins to finance its expenses. Consequently, people started hoarding the higher-quality silver coins and only used the debased coins in transactions, leading to more debasement and eventually the collapse of the Roman monetary system. 2. 1965 U.S. Coinage Act: The U.S. government replaced silver coins with base metal coins (copper-nickel alloy) that had a lower intrinsic value but the same face value. As a result, people started hoarding the silver coins and only used the new base metal coins in transactions, leading to Gresham's Law in action.

Gresham's Law often comes into play when governments try to intervene in monetary systems, such as changing the metal content of coins or printing money without sufficient backing from reserves. Although we mostly use paper currency and digital transactions nowadays, the principle of Gresham's Law still applies in situations when a currency's intrinsic value is debased or inflated due to monetary policy decisions. This can be seen when countries experience hyperinflation, which leads to consumers losing faith in the national currency and switching to more stable currencies for transactions, effectively driving the bad money out of circulation. In summary, Gresham's Law is a fundamental economic principle that explains the tendency for bad money to drive out good money in circulation when both have equal legal tender status. This principle remains relevant in modern economies and various historic examples illustrate its validity in real-world scenarios.