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
- The statute bears the name Thomas Gresham, an English businessman who provided financial guidance to the English crown. It applies to commodities currencies as well as a variety of things and goes beyond paper money.
This adage describes a situation that happens when exchange rates set by the government diverge from market rates, causing undervalued money to be removed from circulation. - Gresham’s Law comes into play anytime governments arbitrarily set prices, resulting in a commodity’s undervaluation in relation to its market exchange rate. The commodity is forced off the official market by this undervaluation.
- Black Market: In these situations, since the undervalued good is no longer accessible through official channels, the only option for purchasing it is through the black market.
- items Outflow: When a nation’s prices are artificially depressed by the government, certain items may leave the country.
Application to Commodity Money
- When a government controls the exchange rate of commodity money, such as gold and silver coins, considerably below their market value, Gresham’s Law is particularly obvious. In reaction, some people may hoard or melt these coins in order to sell them for their higher intrinsic value than the rate set by the government.
Recent Example in Sri Lanka
- Gresham’s Law was observed during Sri Lanka’s economic crisis when the country’s central bank regulated the exchange rate between the Sri Lankan rupee and the dollar.
- Rupee Overvaluation: Despite the black market rate suggesting a higher value, the government regulated that the price of the U.S. dollar should not surpass 200 Sri Lankan rupees. The U.S. dollar was forced out of the official foreign currency market as a result of the overvaluation of the rupee, which also caused a decrease in the availability of dollars.
- Black Market Deals: People who needed U.S. dollars for international transactions were forced to buy them on the black market for more than 200 Sri Lankan rupees each dollar.
Conditions for Gresham’s Law to Apply
- Gresham’s Law is in effect whenever fixed exchange rates between currencies are established and enforced by the government.
- Effective Enforcement: For the law to take effect, authorities must effectively enforce these rates.
Anti-thesis Concept: Thiers’ Law
- In the absence of governmental-imposed exchange rate fixings, the converse of the adage “Good Money Drives Out Bad” takes place. People frequently switch from currencies they think to be of lower quality to those they believe to be of higher quality, which results in the domination of “good money.”
- Thiers’ Law: Thiers’ Law is a complementary principle to Gresham’s Law and is named for the French statesman Adolphe Thiers.
