Daily Current Affairs : 13-September-2023
In the world of economics, principles often carry the names of the thinkers who first articulated them. One such principle is Gresham’s Law, named after the English financier Sir Thomas Gresham. At its core, Gresham’s Law states that “bad money drives out good” when a government sets an official exchange rate that differs from the market rate. In this essay, we will explore the impact of Gresham’s Law, both in terms of currency and commodities, with practical examples.
The Impact of Gresham’s Law
When Undervalued Currency Prevails
When a government fixes the exchange rate at a level lower than the market rate, it undervalues one of the currencies in circulation. The immediate consequence of this is that the undervalued currency becomes less desirable for transactions. People prefer to hoard or use the more valuable currency, considering it “good money,” while spending the undervalued currency, labeled as “bad money.”
Currency Shortages and Fixed Prices
The undervalued currency, often considered as “bad money,” tends to disappear from daily transactions. This phenomenon can lead to currency shortages, especially when the demand for the “good money” exceeds its supply. People prefer to hold on to the more valuable currency, causing scarcity in its circulation.
Application Beyond Paper Money
It’s important to note that Gresham’s Law is not limited to paper currencies alone; it extends its influence to commodities as well. Governments, in their attempts to control markets, may forcibly undervalue certain goods, causing them to vanish from the formal market.
Gresham’s Law in Practice: A Simple Example
To better understand Gresham’s Law, let’s consider a hypothetical example involving two types of coins: gold coins and copper coins. In this fictional country, the government establishes an official exchange rate, declaring that 10 copper coins are equivalent in value to 1 gold coin, despite the market valuing them differently.
Hoarding of Good Money
As soon as this official rate is imposed, people start recognizing the difference in value between the two types of coins. Gold coins, being more valuable in the market’s eyes, become the preferred currency for savings and significant transactions. In contrast, copper coins, considered “bad money” due to their undervaluation, are used for everyday transactions.
Vanishing Good Money
Over time, the circulation of copper coins surges while gold coins become increasingly rare in daily transactions. This situation exemplifies Gresham’s Law, where the undervalued (copper) currency gradually displaces the more valuable (gold) currency from everyday use.
Important Points:
Impact of Gresham’s Law:
- Undervalued currency displaces more valuable currency from circulation.
- Bad money (undervalued) drives out good money (more valuable) in transactions.
- Currency shortages can occur when demand for good money exceeds supply due to fixed exchange rates.
- Gresham’s Law applies not only to paper currencies but also to commodities.
Gresham’s Law in Practice:
- Government sets an official exchange rate that differs from the market rate.
- People hoard and use the more valuable currency while spending the undervalued currency.
- The undervalued currency (bad money) becomes prevalent in everyday transactions.
- The more valuable currency (good money) becomes scarce in daily use.
Why In News
Gresham’s Law, coined by Thomas Gresham, posits that “bad money drives out good” when the government intervenes in the exchange rate between two currencies, setting it at a level different from the market rate. This phenomenon occurs as people tend to hoard and use the undervalued currency for transactions, reserving the more valuable one, which results in a decrease in the circulation of the higher-quality currency. Consequently, this can lead to economic distortions and unintended consequences in international trade and finance.
MCQs about Gresham’s Law
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What does Gresham’s Law state?
A. Good money drives out bad money.
B. Bad money drives out good money.
C. Money should not be undervalued.
D. Currency shortages are always beneficial.
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When does Gresham’s Law result in currency shortages?
A. When the government sets an official exchange rate higher than the market rate.
B. When demand for good money exceeds supply due to fixed exchange rates.
C. When the market value of currency matches the official exchange rate.
D. When people hoard both good and bad money equally.
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In the example involving gold and copper coins, which coin becomes the preferred currency for savings and significant transactions?
A. Gold coins
B. Copper coins
C. Both gold and copper coins equally
D. Neither gold nor copper coins
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