Gresham's law

Also called: Bad money drives out good · Topic: Money: From Barter to Digital Currency · NCERT: Beyond NCERT

Meaning

Gresham's law says that when two kinds of money circulate side by side at a fixed legal ratio (an exchange rate between them set by law), people hoard or melt the undervalued ("good") money. That is the money whose metal is worth more than its legal value. The overvalued ("bad") money, whose metal is worth less than its legal value, is the only money that stays in circulation. In short: "bad money drives out good."

It matters because it shows that a currency system can break down when the law's value for money and the market's value for its metal move apart. The law does not have to be broken for this to happen. It also explains why modern states keep tight control over how coins are made.

Explanation

How it works

• Step 1: the law fixes a ratio. Two coins must be accepted at the same value. Example: 1 silver coin = 1 copper token.
• Step 2: the market values the metal differently. The silver inside one coin is worth far more than the copper inside the other.
• Step 3: people act in their own interest.
• When they pay someone, they hand over the cheap (bad) money.

• They keep, hide or melt the costly (good) money, because its metal is worth more than its face value (the value written on it).

• Step 4: the result. The good money disappears from markets. Only the bad money circulates.

Worked example (from our notes)

• The law says: 1 silver coin = 1 copper token.
• Metal value: the silver in the coin sells for ₹120. The copper in the token is worth ₹5.
• What a smart person does:
• They pay a shopkeeper ₹1 of face value with a token that costs them only ₹5 in metal.

• They keep the silver coin, or melt it and sell the silver for ₹120.

• Result: silver coins vanish from trade and only tokens are used. This is what happened under Muhammad bin Tughlaq.

When the law holds and when it does not

• Condition 1: a fixed legal ratio. The law applies only when the state forces both moneys to be accepted at the same value.

• If people could freely set a different price for the good coin, the good coin would simply trade at a higher price and would not disappear.

• Condition 2: the metal value differs from the face value. The bigger the gap, the faster the good money is hoarded.

• What makes it weaker:
• Token money (money whose face value is higher than its metal value) gives people no reason to melt it.
• Laws that punish melting and counterfeiting remove the profit from hoarding and forging.
• A government monopoly on minting keeps the supply of bad money under control.

In India

• Muhammad bin Tughlaq's token currency (c. 1329-30): this is the classic Indian case.
• He issued brass and copper tokens at the face value of silver coins.
• Brass and copper were cheap and the tokens were easy to copy, so people forged them in huge numbers.
• People held on to the silver coins and paid their bills with tokens. The tokens lost value and had to be withdrawn.

• Lesson: token money works only if the issuer can control its supply.

• Today's safeguards under the Coinage Act, 2011:

• Melting or destroying coins, or making coins without authority, is punishable with jail and a fine [1]. This removes the gain from melting a coin whose metal might be worth more than its face value.
• The Government decides each coin's denomination, size, design, metal mix and standard weight [1].
• "Mint" means the Security Printing and Minting Corporation of India Ltd (SPMCIL), or another body set up or authorised by the government [2]. SPMCIL has four mints, at Mumbai, Hyderabad, Kolkata and NOIDA [3].

• Coins are minted by the Government of India but put into circulation only through the RBI, under Section 38 of the RBI Act [3].

• Modern coins are token money. They are alloys made mostly of iron, a mix called ferritic stainless steel. Their metal is worth less than their face value, so nobody gains by melting them.

Don't confuse with

• Counterfeiting: counterfeiting means making fake money illegally. Gresham's law is about people's choice of which legal money to spend and which to keep. Under Tughlaq both happened together: forgery added to the bad money, and Gresham's law pushed out the good money.
• Token money: token money is a type of money (face value higher than metal value). Gresham's law is a behaviour that shows up when token money and full-value money circulate at a fixed ratio.
• Commodity money: this is money that has value of its own, like grain, cattle or gold coins. In Gresham's law it is usually the good money that gets hoarded.
• Legal tender: legal tender is money that the law says must be accepted as payment. The fixed legal ratio is what makes Gresham's law work, because both coins must be accepted even though their metal values differ.

Prelims Hooks

• Gresham's law: bad (overvalued) money drives out good (undervalued) money from circulation. Trap: it is not "good money drives out bad".
• "Good" money = metal worth more than its legal value, so it is hoarded or melted. "Bad" money = metal worth less than its legal value, so it keeps circulating.
• The law works only under a fixed legal ratio between the two moneys.
• Tughlaq's brass and copper tokens (1329-30) failed because they were forged on a large scale and had to be withdrawn.
• Under the Coinage Act, 2011, melting or destroying coins is a punishable offence [1].
• Trap: the RBI does not mint coins. The Government issues them, and the RBI only distributes them under Section 38, RBI Act [3].

Mains Points

• Money's value rests on trust and supply control.
• Commodity money carried its value in its metal. Token money depends entirely on how much people trust the issuer.
• Tughlaq's experiment shows that when supply goes out of control (forgery), bad money floods the market, good money is hoarded, and the system collapses.

• Today's monopoly on minting, penalties for melting and counterfeiting [1], and the anti-counterfeiting aim of the 2016 demonetisation all follow the same logic.

• Designing coins is a policy choice.

• If the metal inside a coin becomes worth more than its face value, people have a reason to melt it. Coins then vanish from circulation, which is Gresham's law at work.

• Keeping face value above metal value, through cheap alloys like ferritic stainless steel, and banning melting [1] protects the supply of coins.

• Fiscal and monetary roles are split.

• The Government mints coins and bears their liability, while the RBI distributes them [3]. Banknotes are issued by the RBI.
• Clear rules on who issues what, backed by the Coinage Act, 2011 [1], prevent the kind of weak supply control that ruined Tughlaq's tokens.

Related concepts

• Commodity money
• Karshapana
• Coinage
• Minting

Read more

• Commodity money and coinage in India