Gresham's law states that "bad money drives out good."
It applies when the government fixes the exchange rate of two currencies at a ratio different from the market exchange rate.
Price Fixing Consequences: When a government fixes the price of a currency below the market exchange rate, the undervalued currency tends to disappear from circulation, while the overvalued currency remains but may not find enough buyers.
Market Exchange Rate: The market exchange rate is the equilibrium price at which currency supply equals demand.
Currency supply increases with a rising price and decreases with a falling price, while demand decreases with a rising price and increases with a falling price.
Currency Shortage: Fixing a currency's price below the market rate can lead to a shortage of that currency, as demand outpaces supply.
The term "Gresham's law" is named after English financier Thomas Gresham, who advised the English monarchy on financial matters.
It applies not only to paper currencies but also to commodity currencies and other goods.
Application to Commodity Money
Gresham's law can be observed when governments fix the exchange rate of commodity money (e.g., gold and silver coins) below the market price of the underlying commodity.
People may stop using or even melt the commodity money to obtain the higher market price.
Sri Lankan Example
The law was evident during an economic crisis in Sri Lanka when the central bank fixed the exchange rate between the Sri Lankan rupee and the U.S. dollar, causing the U.S. dollar to be undervalued.
This led to a decline in the supply of dollars in the formal foreign exchange market, forcing people to buy dollars from the black market at higher rates.
Gresham's law applies when the government legally fixes exchange rates.
In the absence of such government intervention, good money tends to drive out bad money, a concept known as Thiers' law.
Thiers' law, named after French politician Adolphe Thiers, states that "good money drives out bad." In a free-choice scenario, people stop using poor-quality currency and adopt better-quality currency.
Rise of Cryptocurrencies:
The rise of private cryptocurrencies is seen as an example of good money issued by private entities displacing bad money issued by governments.
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