Table of Contents
- What Is Gresham's Law?
- Key Takeaways
- Understanding Gresham's Law
- Good Money vs. Bad Money
- Gresham's Law and Legal Tender
- Important Note on Stable Currencies
- Example of Gresham's Law
- What Are Legal Tender Laws?
- How Does Gresham's Law Apply When Both Paper and Precious Metal Coins are in Circulation?
- How Does the Use of a Gold Standard Affect Gresham's Law?
- The Bottom Line
What Is Gresham's Law?
Let me explain Gresham's Law directly: it's a principle stating that 'bad money drives out good' and applies to currency markets. This law came from the historical use of precious metals in coins and their values. Now that we've moved away from metallic standards, it often describes how different currencies behave in global markets.
Key Takeaways
Sir Thomas Gresham, who lived from 1519 to 1579, wrote about coin values and minting as a financier. Gresham's Law says 'bad money drives out good.' It notes that legally overvalued currency pushes undervalued currency out of use. The law highlights the impacts of currency debasement.
Understanding Gresham's Law
Sir Thomas Gresham was a financier from 1519 to 1579 who wrote on coin values and minting; he later founded the Royal Exchange in London. When Henry VIII altered the English shilling by replacing much of the silver with base metals, people hoarded the higher-silver coins, which were worth more than face value.
Both types of coins were in circulation and accepted as exchange. I want you to see that Gresham observed bad money driving out good money. Bad money has equal or less value than its face; good money has potential for more. People use bad money first and hold good money. The Scottish economist Henry Dunning Macleod credited this to Gresham in the 19th century.
Good Money vs. Bad Money
Historically, mints made coins from gold, silver, and other precious metals, giving them value. Issuers sometimes reduced precious metal content and passed coins as full value. New coins with less metal had lower market value and traded at a discount, while old coins kept higher value.
Legal tender laws required new coins with less metal to have the same face value as old ones. This made new coins overvalued legally and old ones undervalued. Governments used this to gain revenue and repay debts with new coins at par.
When forced to treat both as equal, people pass on less valued coins quickly and hoard old ones, debasing the currency and reducing purchasing power. To counter this, governments blame speculators, impose controls, ban coin removal, or seize precious metals.
Gresham's Law and Legal Tender
You see Gresham's Law in modern economies with legal tender laws. When all units must be accepted at face value, the traditional law applies. Without enforced laws, it reverses: good money drives out bad, as people reject less valuable money.
With paper money as legal tender, issuers print more, causing ongoing debasement and inflation as the norm. If a currency loses value fast, people switch to stable foreign ones, even against penalties.
In Zimbabwe's 2008 hyperinflation, the dollar was legal but abandoned, forcing the government to accept dollarization. Without enforcement, good money drove out bad.
Important Note on Stable Currencies
Stable currencies like the U.S. dollar or euro act as good money, circulating internationally. Weaker currencies from less developed nations stay mostly within their borders and count as bad money.
Example of Gresham's Law
In 1982, the U.S. changed the penny to 97.5% zinc, making pre-1982 pennies worth more than post-1982 ones at the same face value. Debasement and inflation raised copper prices from $0.6662/lb. in 1982 to $3.0597/lb. in 2006, dropping the penny's purchasing power by nearly 80%.
People started melting old pennies for copper, so the U.S. set penalties: up to $10,000 fine or five years in prison.
What Are Legal Tender Laws?
Countries use legal tender laws to define what currency settles debts, taxes, contracts, fines, or damages. National currency is legal tender everywhere.
How Does Gresham's Law Apply When Both Paper and Precious Metal Coins are in Circulation?
Gresham's Law shows when paper notes circulate with gold or silver coins. During the U.S. Revolutionary War, bad paper money drove good gold and silver coins out of circulation.
How Does the Use of a Gold Standard Affect Gresham's Law?
The U.S. dollar became the world's reserve under the 1944 Bretton Woods Agreement, backed by gold. Now with fiat currencies, Gresham's Law examples are rare. Bretton Woods required currencies convertible to dollars, and dollars to gold for foreign governments.
The Bottom Line
Gresham's Law states 'bad money drives out good' as a monetary principle for currency markets. It applied to precious metal coins historically. With fiat currencies now global, such examples are rare.
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