Monday, November 08, 2004

Gresham's Law

Most introductory economics texts make some reference to the so called “Gresham’s Law which is usually stated as “bad money drives out good money”. What this means is that when two types of money have the same face value within a region but are valued differently outside the region, the one with the higher value outside will be horded and the one with the lower value will be used for spending.

You are probably thinking “why a country would have two currencies and why the currencies have the same value within the country and a different value outside the country”. The economist Robert Mundell in an article entitled “Uses and Abuses of Gresham's Law in the History of Money” gives the example of gold or silver coins which have the same face value (i.e., all the quarters are worth twenty-five cents each) but, due to wear, the older coins have slightly less weight so that when they are melted down the older coins yield a lower amount of the precious metal. For day to day transactions, a thirty year old worn quarter is just as good as a brand new quarter when put in a vending machine or given to the cashier in the store. But, if you go abroad and try to sell the coins for their metal content you will receive less for the old coins than the new ones since the old ones have lost some of their gold or silver content due to wear. Therefore, people who have access to buyers of gold or silver will save the newer coins when they receive them and spend the older ones.

An example of this phenomenon occurred in the United States about forty years ago during the 1960s when the price of silver began to rise. Up until that time dimes, quarters and half dollars were almost 100% silver (an alloy was added to increase hardness and decrease wear and this resulted in their not being pure silver). At this point the U.S. Treasury had the mint reduce the silver content by manufacturing “sandwich” type dimes, quarters and half dollars using a copper alloy center with a layer of silver on the top and bottom. Except for the copper colored center when observed sideways, the new coins looked and felt the same as their older silver counterparts. But the value of the silver and copper in the new coins was less than the face value of the coin (i.e., if you melt down a quarter the value of the resulting metal is less than twenty five cents) while the value of the silver in the old coins was worth more than the face value of the coin. The old, pre-1960s dimes, quarters and half dollars and the new, post 1960s dimes, quarters and half dollars are still legal tender and can be used interchangeably for purchases. BUT, all of the old silver coins have disappeared into coin collections or have been melted and sold for more than their face value. If you should be fortunate enough to encounter one of these old coins, which, look like the present ones, keep it as it is worth considerably more than the ten, twenty five or fifty cents exchange value in a store.

And, who was this Gresham fellow who postulated this law? Sir Thomas Gresham was a successful businessman and financial adviser to Queen Elizabeth I (1533 – 1603) who observed the phenomenon, like many before him, that when two currencies have the same face value at home but are valued differently abroad, the one with the higher value abroad will be horded and the one with the lower value used in exchange locally. While this had been observed and written about for twenty centuries before Gresham made the observation, it was Gresham whom the British economist H. D. Macleod referred when Macleod described the phenomenon in a publication in 1858 and named it “Gresham’s Law”.

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