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Gresham's law

From Academic Kids

Gresham's law is stated as: "Bad money drives good money out of circulation".

Gresham's law applies specifically when there are two forms of commodity money in circulation which are forced, by the application of legal tender laws, to be respected as having the same face value in the marketplace. It is named after Sir Thomas Gresham, an English financier in Tudor times.

Contents

Good and bad money

The terms "good" and "bad" money are used in a technical sense, and with regard to exchange values imposed by legal tender legislation, as follows:

Good money

Good money is money that has little difference between its exchange value and its commodity value. In the original discussions of Gresham's law, money was conceived of entirely as metallic coins, so the commodity value is the market value of the bullion of which the coins are made.

An example is the US dollar, which, prior to the 1900s was equal to 1/20.67 ounce (1.5048 g) of gold, and carried an exchange value roughly equal to its gold bullion market value.
It is worth noting that in the absence of legal tender laws, metal coin money will freely exchange at somewhat above bullion market value. (This is not a purely theoretical result, but rather can be observed today in bullion coins such as the Krugerrand and the U.S. Gold Eagle.) Honestly coined money is of a known purity, and in a convenient form to handle. People prefer to trade in coins than in anonymous hunks of bullion, so they attribute more value to the coins. Thus, coining is frequently profitable.

Bad money

Bad money is money that has a substantial difference between its commodity value and its market value, where market value is lower than exchange value.

In Gresham's day, bad money included any coin that had been "debased," Debasement was often done by members of the public, cutting or scraping off some of the metal. Coinage could also be debased by the issuing body, whereby less than the officially mandated amount of precious metal is contained in an issue of coinage, usually by alloying it with base metal. Other examples of "bad" money include counterfeit coins made from base metal. In all of these examples, the market value was the supposed value of the coin in the market.
In the case of clipped, scraped or counterfeit coins, the market value has been reduced by fraud, while the exchange value remains at the higher value. On the other hand, with coinage debased by a government issuer the market value of the coinage was often reduced quite openly, but the exchange value of the debased coins was held at the higher level by legal tender laws.
All modern money is "bad money" in this sense, since fiat money has entirely replaced the commodity money to which Gresham's law applies. The ubiquity of fiat money could indeed be taken as evidence for the truth of Gresham's law.

Theory

Gresham's law says that any circulating currency consisting of both "good" and "bad" money, where both forms are required to be accepted at equal value under legal tender law, quickly becomes dominated by the "bad" money. This is because people spending money will hand over the "bad" coins rather than the "good" ones, keeping the "good" ones for themselves.

Consider a customer purchasing an item which costs five pence, who has in his possession several silver sixpence coins. Some of these coins are more debased, while others are less so -- but legally, they are all mandated to be of equal value. The customer would prefer to retain the better coins, and so offers the shopkeeper the most debased one. In turn, the shopkeeper must give one penny in change -- and has every reason to give the most debased penny. Thus, the coins that circulate in the transaction will tend to be of the most debased sort available to the parties.

If "good" coins have a face value below that of their metallic content, individuals may melt them down and sell the metal for its higher bullion value. For an example of this, we will look at the 1965 US Half-dollars which were made from only 40% silver. The previous year the half-dollar was 90% silver. With the release of the 1965 dollar, which was legally required to be accepted at the same value as the previous year's 90% halves, the older 90% silver coinage of the US quickly disappeared from circulation, and the debased money was allowed to circulate in its stead. As the price of bullion silver rose above the face value of the coins many of those old half-dollars were melted down.

In addition to being melted down for its bullion value, money that is considered to be "good" tends to leave an economy through international trade. International traders are not bound by legal tender laws the way citizens of the country are, so they will offer higher value for good coins than bad ones, and thus higher value than can be obtained within the country. The good coins may leave their country of origin to become part of international trade. Thus, the good money is driven out of the country of issue, escaping that country's legal tender laws and leaving the "bad" money behind. This occurred in Britain during the period of the Gold Exchange Standard.

Origin of the title

George Selgin in his paper "Gresham's Law" offers the following comments:

The expression "Gresham's Law" dates back only to 1858, when British economist Henry Dunning Macleod (1858, p. 476-8) decided to name the tendency for bad money to drive good money out of circulation after Sir Thomas Gresham (1519-1579). However, references to such a tendency, sometimes accompanied by discussion of conditions promoting it, occur in various medieval writings, most notably Nicholas Oresme's (c. 1357) Treatise on money, and can even be found in much earlier works, including Aristophanes' The Frogs, where the prevalence of bad politicians is attributed to forces similar to those favoring bad money over good.

The passage from The Frogs referred to is as follows; it is usually dated at 405 B.C.:

The course our city runs is the same towards men and money.
She has true and worthy sons.
She has fine new gold and ancient silver,
coins untouched with alloys, gold or silver,
each well minted, tested each and ringing clear.
Yet we never use them!
Others pass from hand to hand,
sorry brass just struck last week and branded with a wretched brand.
So with men we know for upright, blameless lives and noble names.
These we spurn for men of brass....

Gresham's context

According to George Selgin in his paper "Gresham's Law":

As for Gresham himself, he observed "that good and bad coin cannot circulate together" in a letter written to Queen Elizabeth on the occasion of her accession in 1558. The statement was part of Gresham's explanation for the "unexampled state of badness" England's coinage had been left in following the "Great Debasements" of Henry VIII and Edward VI, which reduced the metallic value of English silver coins to a small fraction of what that value had been at the time of Henry VII. It was owing to these debasements, Gresham observed to the Queen, that "all your ffine goold was convayd ought of this your realm."

Gresham made his observations of good and bad money while in the service of Queen Elizabeth, with respect only to the observed poor quality of the British coinage. The previous monarchs, Henry VIII and Edward VI, forced the people to accept debased coinage by means of their legal tender laws. Gresham also made his comparison of good and bad money where the precious metal in the money was the same. He did not compare silver to gold, or gold to paper.

Gresham's law in reverse

In an influential theoretical article, Rolnick and Weber (1986) argued that bad money would drive good money to a premium rather than driving it out of circulation. However their research did not take into account the context in which Gresham made his observation. Rolnick and Weber ignored the influence of legal tender legislation which requires people to accept both good and bad money as if they were of equal value. They also focussed mainly on the interaction between different metallic moneys, comparing the relative "goodness" of silver to that of gold, which is not what Gresham was speaking of.

The experiences of dollarization in countries with weak economies and currencies (for example Israel in the 1980s, the Eastern European countries in the period immediately after the collapse of the Soviet bloc, or South American countries throughout the late twentieth and early twenty-first century) may be seen as Gresham's Law operating in its reverse form (Guidotti & Rodriguez, 1992), since in general the dollar has not been legal tender in such situations, and in some cases its use has been illegal.

These examples show that in the absence of legal tender laws, Gresham's law works in reverse. If given the choice of what money to accept, people will transact with money they believe to be of highest long-term value. However, if not given the choice, and required to accept all money, good and bad, they will tend to keep the money of greater perceived value in their possession, and pass on the bad money to someone else. Said in another way, in the absence of legal tender laws, the seller will not accept anything but money of real worth (good money), while the existence of legal tender laws will force the seller to accept money with no commodity value (bad money). Thus, the buyer will always try to spend his bad money first, but in the absence of legal tender laws, the seller will not accept money with no real worth.

Analogical extensions of Gresham's law

The Gresham's Law principle has been applied, by analogy, to many different fields. For example, in higher education, "Diploma mills" have come into existence producing low-cost qualifications which are often of little or no market value. According to Gresham's law as it applies to money, these "bad" diplomas ought to drive out the "good diplomas". However, unlike laws for money, there is no law requiring employers to accept all diplomas as being of equal value. Consequently, each employer is free to assess the value of qualifications as they see fit.

References

  • Guidotti, P. E., & Rodriguez, C. A. (1992). Dollarization in Latin America - Gresham law in reverse. International Monetary Fund Staff Papers, 39, 518-544.
  • Rolnick, A. J., & Weber, W. E. (1986). Gresham's law or Gresham's fallacy (http://minneapolisfed.org/research/qr/qr1012.html). Journal of Political Economy, 94, 185-199.
  • Selgin, G., University of Georgia (2003). Gresham's Law (http://www.eh.net/encyclopedia/contents/selgin.gresham.law.php).

See also

ja:グレシャムの法則 pl:Prawo Kopernika-Greshama

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