Gresham’s law

The law, named after English financier Thomas Gresham, came into play recently during the economic crisis in Sri Lanka, when Sri Lanka had fixed the exchange rate between the Sri Lankan rupee and the U.S. dollar.

What is Gresham’s law:

• Gresham’s law is a principle that states that “bad money drives out good“.
• Gresham’s law comes into play when the exchange rate between two 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 to go out of circulation.
  • The overvalued currency remains in circulation but it does not find enough buyers.
• The law applies not just to paper currencies but also to commodity currencies and other goods.
  • Whenever the price of any commodity is fixed arbitrarily such that it becomes undervalued when compared to the market exchange rate, this causes the commodity to disappear from the formal market.

Example of Gresham’s law:

• If a government fixes the exchange rate/price of a commodity money (such as gold and silver coins) far below than the market price of the commodity backing them.
• People who hold the commodity money will stop offering the money at the price fixed by the government.
  • They may even melt such commodity money to derive pure gold and silver that they can sell at the market price, which is higher than the rate fixed by the government.

What is market exchange rate?

• It is an equilibrium price at which the supply of a currency is equal to the demand for the currency.
• The supply of a currency in the market rises as its price rises and falls as its price falls.
• The demand for a currency falls as its price rises and rises as its price falls.

Ref: Source