Gresham’s Law is a theory that predicts what will happen when two kinds of money circulate in an economy at the same time. However, the Gresham’s Law is conditional on certain circumstances. Outside of those circumstances, its predictions may not come true.
II. The Story of Gresham’s Law
The story of Gresham’s Law originates from an interesting phenomenon observed by Sir Thomas Gresham, a financier in the 15th century. During that time, the English silver coin was the legal tender of England.
Not all the English silver coins one could find in the market were the same. The reason was the Great Debasement happened in 1544: King Henry VIII ordered to reduce the content of silver in the new coins produced, and to add cheap metals in them. This made the newly produced silver coins less valuable. We can therefore separate the silver coins into 2 types: Those perfect silver coins made before the Great Debasement (let us call them “good money”), and those made after the start of the Great Debasement (let us call them “bad money”). “Good money” was more valuable than “bad money” due to their higher silver content.
We can now look at Gresham’s observation: Silver coin, at that time, was an asset to represent how wealthy a person was. From our understanding of money today, the value of a silver coin on settling transactions and wealth accumulation should be the same. That means, a $1 silver coin should be the same when it is used to buy goods or deposited in a bank. It gives you the value of 1 unit of dollar.
A unit of “bad money” could not buy a good that was worth a unit of “good money” since they were less valuable. However, the England government’s legal tender law made the “bad” silver coins as valuable as “good” silver coins when they were used to settle transactions.
The result of the legal tender law was that “bad money” was now more valuable than before when it was used to settle transactions. People would then save up their “good money” for wealth accumulation and use their “bad money” for market transactions. As a result, it became difficult to find “good money” circulating in the market. This result was later summarized by the catchy phrase “bad money drives out good money”.
III. A Newly Proposed Law to Counter Gresham’s Law
Some economists have investigated whether there are any other possible effects on money circulation under a situation similar to Gresham’s observations. They hope to find out the conditions under which “bad money drives out good money” holds true. Rolnick and Weber (1986) are two of them. Let us take a look at what their theory is about.
They made the following assumptions in their theory:
1. Sellers are free to set the price of a good in whatever type of money (either “good money” or “bad money”) they desire
2. Buyers are free to purchase the good by either “good money” or “bad money”, no matter which money the sellers chose to set, with the presence of premium and discount (The idea of premium: To make it fair, “good money” must worth more than “bad money” when it is used to buy goods. The same concept for discount: “bad money” must worth less than “good money” when it is used to buy goods.)
Here is their analysis: Suppose “good money” and “bad money” are now circulating in the market again, and the sellers have already chosen to use “bad money” to mark the prices. A buyer now wants to purchase a good from a seller. He has to decide how he pays for the good. If he pays by “good money”, he has to first find out the premium, then calculate the amount of money he has to pay. However, if he pays by “bad money”, he just needs to pay by the amount the seller has already marked. This helps him to save a bit of time. Therefore, they will use “bad money” to pay for the good. When all buyers do the same, only “bad money” will be used in all transactions, and “bad money” will be able to drive out “good money”.
But what will happen if the sellers choose to use “good money” to mark the prices? This time the time-saving method for buyers is to pay for the goods by “good money”. They do not need to know the discount of “bad money”. In this case, the opposite of Gresham’s Law, “good money drives out bad money”, will result.
The central idea of the theory proposed by Rolnick and Weber is that the key factor that determines how monies circulate is indeed the convenience of settling market transactions. Both buyers and sellers agree to use the money that is being used to mark the price of goods at the beginning, and save time for both parties to settle transactions. This makes both “bad money drives out good money” and “good money drives out bad money” possible.
IV. A Real Historical Case
Looking at the economic history, the use of Spanish milled dollar in the US during the 18th century is one of the counter examples of Gresham’s Law.
At that time, there were two main types of legal tenders circulating in the US. One was the US silver dollar: each of them contains about 371.25g of pure silver. Another was the Spanish milled dollar: each of them contains about 373.5g of pure silver, slightly higher than that of in the US silver dollar. Therefore, we may say the Spanish milled dollar was the “good money”, while the US silver dollar was the “bad money”.
To allow both types of monies to be used in the market at the same time, the Spanish dollar was circulated at a premium ranging from 0.25% to 1%. This prevented the Spanish milled dollar from being driven out of the circulation. Since the Spanish dollar and the US dollar were the same in terms of buying goods and also wealth accumulation under the presence of premium. Therefore, the US dollar, which is the “bad money”, failed to drive out the Spanish dollar. The Spanish dollar was also able to circulate with the US dollar in the market at the same time. In 1830, the Spanish dollar still constituted 22% of the total coin value in the US.
Rolnick, Arthur J., and Warren E. Weber. “Gresham’s Law or Gresham’s Fallacy?” Journal of Political Economy 94(1) (February 1986), 185-99.