Gresham's Law - Explained
What is Gresham's Law?
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What is Gresham's Law?
Gresham's law is a monetary principle based on observation in economics that in currency evaluation, when two coins are equal in face value but unequal in intrinsic value (cost of material), the one having less intrinsic value tends to remain in the market circulation, whereas the other disappears to be hoarded or exported as bullion. The law is named after Sir Thomas Gresham (1519-79), a leading English financial adviser to Queen Elizabeth I.
Why is Gresham's Law Important?
It states that "bad money drives out good." Where bad refers to the coin with lesser intrinsic value and good refers to the coin with more intrinsic value. In older times, coins were made of gold, silver and other precious metals, which gave them their value. Over time, there was a decrease in the number of precious metals used in making coins because the metals were worth more than the face value mentioned in the coin. The new coins were given the same face value as the existing coins to facilitate the transactions conducted by the people. Because the intrinsic value of the old coins was higher than the coin's face value, people started melting down the coins and sell the metal itself, or hoarding them as a store of value. The new coins with less intrinsic value were considered as overvalued and hence its expenditure increased more than coins with more intrinsic value as they were considered as undervalued, leading to hoarding effect, driving them out of circulation as currency.
Name Origin of Gresham's Law
In the administration of Queen Elizabeth, different metals were in circulation as currency. Some coins were of more intrinsic value than others of the same monitory value. The coins made of the inferior metal tended to drive the better out of circulation as currency. This is because the better coins were either hoarded or melted down and sold as bullion or in foreign exchanges, or used in the fine arts. This was observed by Gresham and also stated at least 40 years before Gresham by Nicolaus Copernicus. The theory was not formalized until the middle of the 19th century by Scottish economist Henry Dunning Macleod in name of Sir Gresham. In some parts of Europe (mostly Central and Eastern Europe) this law is also known as Copernicus Law.
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