Description
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Context: Gresham’s law is in the news.
Details
- Gresham's Law is a fundamental economic principle that originated from the observations of Sir Thomas Gresham, a financier and founder of the Royal Exchange of the City of London, who lived from 1519 to 1579.
- The essence of Gresham's Law can be summarized as "bad money drives out good money." This principle has historically been associated with the use of precious metals in coinage but is also applicable to modern fiat currency systems.
Key Highlights
- Gresham's Law is named after Sir Thomas Gresham, who noticed the phenomenon during his lifetime. He observed how changes in the composition and value of coins affected their circulation.
- Gresham's Law suggests that when two forms of money are in circulation, one of which is of lower intrinsic value (bad money) and the other of higher intrinsic value (good money), people tend to use the lower-value money for transactions and hoard the higher-value money. This behaviour is driven by the desire to minimize losses associated with holding the less valuable currency.
- Historically, coins were often made from precious metals like gold and silver. When rulers or governments reduced the amount of precious metal in coins while maintaining their face value, the new coins had less intrinsic value compared to older coins with higher metal content.
- Legal Tender Laws: Gresham's Law is often observed in the context of legal tender laws, which require that both old and new coins of different intrinsic values be accepted at their face value. This legal requirement forces people to use the less valuable currency for transactions and hold onto the more valuable currency.
- Currency Debasement: Governments sometimes debased their currency by reducing the precious metal content, allowing them to mint more coins with the same face value. This practice effectively devalued the currency and created a situation where good money (old coins with higher intrinsic value) was hoarded, while bad money (new coins with lower intrinsic value) was used for transactions.
- Modern Application: Gresham's Law can also apply in modern fiat currency systems when the value of a currency is eroded due to factors like inflation or instability. In such cases, people may prefer to use more stable or stronger foreign currencies, effectively driving the depreciating domestic currency out of circulation.
Summary
- Gresham's Law is a historical and economic principle that describes the phenomenon of people tending to use less valuable money for transactions and hoarding more valuable money. It has implications for currency circulation, monetary policy, and the behaviour of individuals in response to changes in the value of money.
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PRACTICE QUESTION
Q. According to Gresham's Law, what behaviour do people exhibit when two forms of money are in circulation, one with lower intrinsic value and the other with higher intrinsic value?
A. People prefer to use higher-value money for transactions.
B. People prefer to use lower-value money for transactions.
C. People use both forms of money interchangeably.
D. People refuse to use either form of money.
Answer: B
Explanation: Gresham's Law suggests that when two forms of money coexist, people tend to use the money with lower intrinsic value (bad money) for transactions while hoarding the money with higher intrinsic value (good money) to preserve its worth.
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