Gresham’s Law
Why does weak money circulate more than strong money? Gresham’s Law answers:
“Bad money drives out good money”.
Think about this hypothetical situation:
You are a service provider and receive your salary in dollars, but, for some reason, this month you received it in Argentine pesos.
Normally, people spend their money on subsistence and save the rest.
But saving Argentine pesos couldn’t be something intelligent, considering the coin devaluation that it has been suffering.
Now, trading the remaining Argentine pesos for dollars can be a better way to save money, because it’s a coin that “tends” to be less devalued in relation to Argentine pesos.
Well, you agree with me that the Argentine peso is more in circulation than the dollar, because the dollar has been saved, and the Argentine peso has been spending, circling in the economy. In this example, the Argentine peso is the “bad coin,” and the dollar is the “good coin.”. In other words, the bad money has driven out the good money.
That’s what Gresham’s Law says.
The Gresham’s Law was named by the economist Henry Dunning Macleod in 1857, and it’s assigned to the financial counselor of Elizabeth I from England, Sir Thomas Gresham.
The synthesis of the theory is the phrase “the bad money drives out the good money.”.
The Law observes that a coin that retains more value, is not diluted and has more trust and stability is considered good money, while bad money is the opposite.
In the Gresham context –the bimetallism era, where gold and silver were the main coins -, discovery of a new gold mine could mean the depreciation of gold against silver, doing the agents to retain silver rather than gold.
This would be a practical example of Gresham’s Law, where the gold becomes bad money, because of the growth of their monetary base, i.e., it was inflated; and the silver good money, becoming a store of value better than gold.
The same happens until today, but rather than discover a new gold mine, the governments prints notes without limits and consequently dilutes their value, diluting people’s purchasing power.
In our example, because of the Argentine peso’s hyperinflation, it wouldn’t be a good practice to save it; the better thing to do would be to get rid of it as soon as possible, and in case you want to save some value, do it with hard money, stable, i.e. good money.
How everyone is spending their Argentine pesos, this coin passes to have a dominant circulation on the market and “drives out” the dollar, which in our fictitious example, passes to be retained as a store of value, because it is a “good coin.”.
Here is Gresham’s Law.
Thanks for reading!
