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Greshams Law: What happens when governments fix Currency Exchange Rates?


From UPSC perspective, the following things are important :

Prelims level : Gresham's Law

Mains level : Not Much

gresham's law

Central Idea

  • The law, named after English financier Thomas Gresham, came into play most recently during the economic crisis in Sri Lanka last year.
  • The Central Bank of Sri Lanka has fixed the exchange rate between the Sri Lankan rupee and the U.S. dollar

About Gresham’s Law

  • Thomas Gresham: The law is named after Thomas Gresham, an English financier who advised the English monarchy on financial matters. It extends beyond paper currencies and applies to commodity currencies and various goods.
  • Bad money drives out good: This maxim illustrates a phenomenon that occurs when government-fixed exchange rates diverge from market exchange rates, causing undervalued currency to be withdrawn from circulation.
  • Arbitrarily Fixed Prices: Gresham’s Law operates whenever governments arbitrarily set prices, causing a commodity to become undervalued compared to its market exchange rate. This undervaluation drives the commodity out of the formal market.
  • Black Market: In such scenarios, the only way to acquire the undervalued commodity is through the black market, as it is no longer available through official channels.
  • Goods Outflow: Countries can also experience the outflow of certain goods when their prices are forcibly undervalued by the government.

Application to Commodity Money

  • Gold and Silver Coins: Gresham’s Law is particularly evident when a government fixes the exchange rate of commodity money, like gold and silver coins, well below their market value. In response, people may hoard or melt these coins to obtain their intrinsic value, which is higher than the government-set rate.

Recent Example in Sri Lanka

  • Economic Crisis in Sri Lanka: Gresham’s Law was observed during the economic crisis in Sri Lanka, where the central bank fixed the exchange rate between the Sri Lankan rupee and the U.S. dollar.
  • Rupee Overvaluation: The government mandated that the price of the U.S. dollar should not exceed 200 Sri Lankan rupees, even though the black market rate indicated a higher value. This overvaluation of the rupee led to a decline in the supply of dollars and pushed the U.S. dollar out of the formal foreign exchange market.
  • Black Market Transactions: Individuals seeking U.S. dollars for foreign transactions were compelled to purchase them from the black market at rates exceeding 200 Sri Lankan rupees per dollar.

Conditions for Gresham’s Law to Apply

  • Government-Imposed Fixed Rates: Gresham’s Law operates when government authorities establish and enforce fixed exchange rates between currencies.
  • Effective Implementation: Effective enforcement of these rates by authorities is essential for the law to take effect.

Anti-thesis Concept: Thiers’ Law

  • “Good Money Drives Out Bad”: In the absence of government-imposed exchange rate fixes, the opposite phenomenon occurs. People tend to abandon currencies they perceive as of lower quality in favour of those they consider better, leading to the dominance of “good money.”
  • Thiers’ Law: This concept, known as Thiers’ Law and named after French politician Adolphe Thiers, complements Gresham’s Law.

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