Gresham’s Law and Its Limitations

In this article we will discuss about the Gresham’s law and its limitations.

Subject Matter of Gresham’s Law:

During the reign of Queen Elizabeth I it was found that debased coins continued to circulate while full-bodied coins were hoarded or melted for their specie content. The Chancellor of the Exchequer under Elizabeth I, Sir Thomas Gresham enquired about this phenomenon in 1558 and came to the conclusion that “bad money drives out good money.” This has come to be known as Gresham’s Law.

Marshall defined this law more explicitly thus, “whenever the specie value of a certain class of coins exceeds their currency value, the coins will begin to go into the melting pot or be exported.” Thus “bad money” refers to debased or clipped or worn out legal tender money such as coins and paper notes.

When full-bodied and debased coins circulate together, people have a tendency to hoard the good and try to pass on the bad ones as medium of exchange. They may even melt the full-bodied coins for bullion in order to export it or use it for jewellery. This actually happened in countries which were on silver or gold standard.

This law also operates under the bimetallic standard when gold and silver coins circulate simultaneously and one metal becomes overvalued relative to the other metal. The metal which is overvalued drives out the undervalued metal out of circulation. Suppose the mint ratio between gold and silver is 1 oz. of gold coin= 15 ozs. of silver coin (1:15). Suppose silver coins become overvalued which means that their money (face) value exceeds their metallic (intrinsic) value.

On the other hand, gold coins become undervalued which means their metallic value exceeds their money value. As a result, let us say the market ratio becomes 1:17. People will thus find it profitable to melt gold coins to exchange 1 oz. of gold for 17 ozs. of silver in the market, and thereby gain 2 ozs. of silver. It is in this way that the overvalued (bad) currency drives out the undervalued (good) currency out of circulation under bimetallism.

Further, Gresham’s law operates when paper currency notes circulate along with gold and or silver coins. In this case paper notes are bad money and gold and or silver coins are good money. This actually happened during the Revolutionary War in the United States of America when the bad paper money drove all gold and silver coins out of circulation between 1775-79.

Limitations of the Gresham’s Law:

There are, however, certain limitations of Gresham’s law so that it will operate only if the following conditions are fulfilled:

1. If the total money in circulation, including, both good and bad money, exceeds the actual monetary demand of the public.

2. If the public is prepared to accept and circulate bad money.

3. If the good money is full-bodied legal tender whose face value equals its intrinsic value.

4. If the total supply of bad money is sufficient to meet the total monetary demand of the public.

With managed paper standard in circulation along with token coins, Gresham’s law is only of limited validity in modern times. Still we find the tendency among people to pass on worn out notes and debased coins first. But this is not Gresham’s law proper because neither fresh notes nor good coins go out of circulation but their use is suspended for a while.