Let us make an in-depth study of Gresham’s law of the monetary systems.
Explanation of the Law:
Gresham’s law states that if two coins are in circulation whose relative face values differ from their relative bullion content, the ‘dearer’ coin will be extracted from circulation for melting down.
(‘Bad Money Drives out Good’.) The law is named after Sir Thomas Gresham (1519-79), a leading English business pay on and financial adviser to Queen Elizabeth I.
Thus, in India, we have one-rupee notes and one-rupee coins. Both are forms of legally good money. Yet, the public sometimes prefer one form of a particular denomination to another, e.g., they may prefer the rupee coin to the paper note. If there is such a preference for one form of money rather than another, it is an example of Gresham’s Law in operation.
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In short, the principle suggests that “bad money tends to drive good money out of circulation when both are full legal tender”. This principle is known as Gresham’s Law, although it was noted by other writers earlier.
The term “bad money” does not mean counterfeit coins. It means worn out, clipped or underweight coins.
When “bad money” and “good money” are both in circulation people will use the “bad money” when making purchases and the “good money” will be hoarded. The natural human tendency is to retain the better coins and pass on into circulation the comparatively old and worn out coins.
In ancient times, when coins made of gold and silver used to be in circulation, the full-weight coins were often melted down for making jewellery and for sale to foreigners by weight. In course of time the entire stock of “good money” might be driven out in this way, so that only “bad money” remained in circulation.
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In modern times full-weight metallic coins are not used. But the principle of Gresham’s Law operates in subsidiary coins and as between new notes and old and soiled notes. People generally try to keep fresh notes and shining coins in their pockets and pay out the soiled notes and worn out coins.
Thus bad money drives good money out of circulation.
Marshall put the law in a general form as:
“Gresham’s Law is that an inferior currency, if not limited in amount, will drive out the superior currency.”
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How does good money disappear from circulation? Good money disappears from circulation through the following ways:
(1) Hoarding:
People hoard the good money and pass out the bad. There is a natural tendency to retain good coins. When payments are being made the comparatively less valuable money will be issued out first. Hence, good coins tend to remain out of circulation.
(2) Melting:
If the good money is a coin, the good coins will be melted down and sold as bullion. The melting of good money is highly profitable under bimetallism. Let us suppose that the Government ratio between gold and silver is 1: 16, while the market ratio is 1: 17. In this case, gold coins will be officially undervalued and silver coins overvalued. Gold coins will be good money and silver coins bad money.
By melting down 1 ounce of gold coin and selling it as bullion, a person will get 17 ounces of silver in the market. By taking 16 ounces of silver to the mint he will get an amount of silver coin in exchange of which he will again secure an ounce of gold coin.
Thus, he will make a clear profit of one ounce of silver. The process will be repeated and, ultimately, all gold coins will disappear. Similarly, if gold becomes over-valued, gold coins will be bad money and all silver coins will be melted down.
(3) Export to foreign countries:
The coin of one country is not legal tender in a foreign country. Hence, foreigners will not accept it as coin but only as bullion. Thus, the bad coins circulate as legal tender in the home country and the good coins if they are standard money are exported as bullion to foreign countries. This is especially the case under bimetallism, because the metal which is undervalued in the home country has necessarily a higher value in a foreign country.
Limitations of Gresham’s Law:
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Gresham’s Law is of less significance under a paper money system. Under a metallic standard the “good money” can be melted down, exported abroad and sold by weight. This cannot be done with paper money or subsidiary coins. Therefore, Gresham’s Law is of very limited applicability in modern times when the paper standard is in almost universal use.
Gresham’s Law cannot operate in the following circumstances:
(i) When the total volume of currency (good money together with bad money) is less than what is needed by the community for exchange purposes. In such a situation both good money and bad money will circulate.
(ii) When the “bad money” is so bad that it is not accepted by the people of a country. So bad money will not circulate and cannot drive good money out.