GRESHAM'S
LAW - ECONOMY
News:
Gresham’s law: what
happens when governments fix currency exchange rates
What's
in the news?
●
The law, named after English financier
Thomas Gresham, came into play most recently during the economic crisis in Sri
Lanka last year, during which the Central Bank of Sri Lanka fixed the exchange
rate between the Sri Lankan rupee and the U.S. dollar.
Key
takeaways:
●
Gresham’s Law, named after Thomas Gresham,
states that “bad money drives out good”
when the government fixes the exchange rate between two currencies at a level
different from the market rate.
Gresham's
Law:
●
The law comes into play when the exchange rate between two moneys or
currencies is fixed by the government at a certain ratio that is different from
the market exchange rate.
●
Such price fixing causes the undervalued
currency — that is, the currency whose price is fixed at a level below the
market rate — to go out of circulation.
●
The overvalued currency, on the other
hand, remains in circulation but it does not find enough buyers.
●
It should be noted that the market
exchange rate is essentially an equilibrium price at which the supply of a
currency is equal to the demand for the currency.
●
Also,
the supply of a currency in the market rises as its price rises and falls as
its price falls; while, on the other hand, the demand for a currency falls as
its price rises and rises as its price falls.
●
So, when the price of a currency is fixed
by the government at a level below the market exchange rate, the currency’s
supply drops while demand for the currency rises.
●
Thus, a price cap can lead to a currency
shortage with demand for the currency outpacing supply.
Impacts:
●
This leads to the undervalued currency going out of circulation, while the overvalued
currency remains but lacks buyers.
●
The law can result in a currency shortage
when demand exceeds supply due to the fixed price.
●
Gresham’s law applies not only to paper
currencies but also to commodities.
●
It can cause goods to disappear from the
formal market when their prices are forcibly undervalued by governments.
Contrast
to Gresham's Law:
●
Thiers’
law, on the other hand, states that “good money drives out bad”
when people have the freedom to choose between currencies, and they prefer
higher-quality currencies.