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Gresham's Law

Gresham's law is usually stated now as, "Bad money drives out good money," and it has turned out to be true in a lot of fields besides finance or economics. It is named after Sir Thomas Gresham, an English financier in Tudor times.

Gresham's law applies specifically when there are two forms of money in circulation:

  • Money that has an intrinsic value -- the value of the material it is made of -- equal to the face value. An example is a 1 gold coin that contains exactly one pound's worth of gold. This is the "good" money.
  • Money that has an intrinsic value less than the face value. In Gresham's day, this was coins that had been "debased," usually by cutting or scraping some of the metal off. Other examples of "bad" money would be counterfeit coins and coins issued by the mint that are made out of metal with a lower market value than the face amount of the coins.

Gresham's law says that the money in circulation tends to be dominated by the "bad" money. This is because people will spend the "bad" coins rather than the "good" ones and either hoard the "good" ones or melt them down and sell the metal for what it's worth.

Why would people do this? Firstly, people holding money as savings would prefer the "good" coins because they will still have their inherent value in the future, and the "bad" ones will eventually be worth no more than their lower inherent value. So the "good" coins are hoarded while the "bad" ones are spent.

Secondly, the increase in the supply of money from the "bad" coins will lead to a general increase in the level of prices (inflation), as sellers will demand more coins for the same amount of goods. Inflated prices in this country will mean that goods in other countries will be relatively cheap, so "good" money will be spent on goods from abroad (and foreign merchants will not accept the "bad" coins at their face value). Thus the "good" coins tend to leave this country, leaving the "bad" ones behind.

The same principle has been applied to many different fields. For example, if diplomas from some high schools are granted only to students who have earned them by satisfying the standards the state has set for graduating, but diplomas from other high schools are handed out to everyone who attended class whether they ever passed a test or not, a prospective employer or a college will have no way of knowing whether a person with a high school diploma did the work to earn it or not, so having a diploma will lose its value as a qualification. As students find out that a good diploma is of no more value to them than a bad one, more and more of them will quit working for a good one and end up with a bad one, so the bad diplomas will tend to drive the good ones out of existence.

[Compare Tragedy of the commons.]



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