Bad Money Drives Out Good Principle: Gresham's Law

The English financier Sir Thomas Gresham (1519–1579), who operated throughout the Tudor era, is the subject of Gresham's Law.

However, the original idea of this principle doesn't belong to Thomas Gresham. It was articulated by Nicolaus Copernicus at least forty years before and attributed to Christian and Islamic academics before Thomas Gresham was even born. The Law is still referred to as the Copernicus Law in various regions of the world, primarily in Central and Eastern Europe.

Gresham's Law is a monetary principle that may be applied to the currency markets and says that "bad money drives out good." Gresham's Law applies to the fluctuating value of coins and their contents during the historical use of precious metals to make coins. The shift to fiat currencies in the global financial system has made instances of Gresham's Law uncommon.

Yet, the principle of 'bad money drives out good money' is still very relevant and teachable in today's economy. That is why we've decided to examine this law more closely and see how it impacts our present.

What Is Gresham's Law?

The idea known as "bad money drives out good" is known as Gresham's Law, and it has applications in the currency markets. The worth of coins made from precious metals in the past and their subsequent production served as the impetus for the Law. The idea has been used frequently to explain the stability and movement of various currencies in international markets since the adoption of metallic value standards.

From 1519 to 1579, Sir Thomas Gresham, a financier by trade, extensively published information about coin valuation and minting. He also formed the Royal Exchange in the City of London. After Henry VIII altered the English shilling's composition by substituting a significant amount of base metal for silver coins, people separated the English shilling coins and hoarded the ones that contained more silver, which was worth more than their actual value.

When paper notes are accepted by the public and used in circulation alongside gold and silver coins, Gresham's Law is clearly in effect. Bad paper money, which was then accepted as payment, drove all fine gold and silver coins out of circulation during the American Revolutionary War.

Both types of money were readily used as legitimate means of exchange and were liquid simultaneously. Gresham saw that the circulation of good money was being driven out by evil money. A currency worth less or equal to its face value is known as bad money. The potential value of good money can exceed its face value. Individuals tend to prioritize using bad money while hoarding good money. In the nineteenth century, Gresham was credited with creating this Law by the Scottish economist Henry Dunning Macleod.

Key Factors of Gresham's Law

When discussing Gresham's Law, two key factors should be considered: legal tender laws and information asymmetry.

Legal Tender Laws

Gresham's Law is clear in a contemporary economy with legal tender laws. Traditional Gresham's Law applies when all currency units are required by Law to be acknowledged at the same face value. Gresham's Law functions in reverse when there are insufficient legal tender rules that are properly implemented, as good money pushes bad money out of circulation and allows individuals to refuse to accept less valuable money.

Since paper money has been accepted as legal tender, money may be printed at will by those in charge of the economy, and as a result, inflation has become the standard in the majority of them. People sometimes quit using currencies that depreciate quickly in favor of more stable foreign currencies, often even in the face of harsh legal penalties.

All currencies must be accepted at face value in accordance with legal tender legislation. Unintentionally, this rule encourages the use of less valuable currencies. Given that others must take them at face value, people inevitably hoard the more precious coins and spend the lesser-value ones.

Information Asymmetry

People frequently struggle to determine an object's actual value, particularly when it comes to historical circumstances like the amount of metal in coins. Because of this knowledge gap and the simplicity with which face value may be identified, there is a proliferation of subpar products in circulation.

Good Money Vs. Bad Money

It's crucial to remember that Gresham's Law of Economics works in situations where there is both "good" and "bad" money present at the same time. When money is considered "good," there isn't much of a gap between its face value and its commodity value, which includes the inherent worth of the metal used in manufacturing. On the other hand, money that is legally tender but commodity value worth is far less than its face value is referred to as "bad" money. To put it briefly, Gresham's Law of Money states that superior currency will be driven out if there is no control over the supply of inferior currency.

The legal relationship between money and precious metals has weakened in recent years. It has significantly weakened, and many have given up on it completely. A continuous trend of inflation characterizes the global economy. In severe cases, hyperinflation can get so bad that money is worthless compared to the paper it is printed on. Foreign currencies usually replace local currencies during hyperinflation, which is an example of Gresham's Law going in reverse. People will switch to more stable foreign currencies when a currency depreciates rapidly, regardless of any legal constraints.

Gresham's Law Today

Gresham's Law of Money doesn't have too much freedom in application in a world where paper is the tool for money transactions. What is referred to as good money can be melted, captured to foreign lands, and sold by volume under a metallic value. This is something that cannot be achieved with paper money or secondary coins. As a result, the Law finds itself less important under a paper-money system.

There are certain circumstances in which this Law of good money and bad money is inapplicable today. Good and bad money will flow regardless of value disparities when the total volume of currency is less than what the community needs as a medium of trade. When the value of bad money or bad currency is low, people reject it, causing currency losses. Good money will continue to exist and be able to smother negative money.

Conclusion

Gresham's Law remains relevant in today's economy, extending beyond traditional coinage to influence how value and trust are perceived. Despite the shift to digital and fiat currencies, the principle illustrates why inferior options can sometimes overshadow superior ones. This concept not only helps us understand currency circulation but also provides insight into broader societal trends and decision-making processes.

Frequently Asked Questions

What Is Gresham's Law?

According to Gresham's Law, the value of a currency that is deemed bad money will eliminate the good money. The least valuable commodity money in circulation among those with comparable face values is referred to as "bad money." That doesn't really matter while using paper money. The worth of coins made from precious metals in the past and their subsequent production served as the impetus for the Law. The idea has been used frequently to explain the stability and movement of various currencies in international markets since the adoption of metallic currency standards.

Why Does the Same Value Matter for Gresham's Law?

Gresham's Law is the economics axiom that states that bad money will drive out good. More specifically, coins made of cheaper metal will be used for payment, whereas coins made of more valuable metal will be hoarded or exported, which will cause them to gradually disappear from circulation if coins made of various values of metal have the same value as legal tender.

What Are Modern Examples of Gresham's Law?

Gresham's Law holds valid in that situations tend to encourage the use of lower-value money rather than face value. Furthermore, it will be true regardless of the time frame in which it occurs. For instance, because of hoarding, silver coins were replaced in the United States in the latter half of the 1990s.