Gresham’s law: what happens when governments fix currency exchange rates

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Last Updated13/09/2023

Gresham’s law refers to the dictum that “bad money drives out good.”
It is named after English financier Thomas Gresham who advised the English monarchy on financial matters.
It comes into play when the exchange rate between two currencies is fixed by the government at a certain ratio different from the market exchange rate.
Such price fixing causes the undervalued currency to go out of circulation.
The overvalued currency, on the other hand, remains in circulation but it does not find enough buyers.

It is an equilibrium price at which the supply of a currency is equal to the demand for the currency.
The supply of a currency in the market rises as its price rises and falls as its price falls.
However, 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.

It applies to paper currencies along with commodity currencies and other goods.
Whenever the price of any commodity is fixed such that it becomes undervalued, it causes the commodity to disappear from the formal market.
The only way to get hold of an undervalued commodity in such cases would be through the black market.
Sometimes, countries can even witness the outflow of certain goods through their borders when they are forcibly undervalued by governments.

Gresham’s law can be seen at play whenever a government fixes the exchange rate or price of a commodity money far below than the market price of the commodity backing them.
In such cases, people who hold commodity money would stop offering the money at the price fixed by the government.
They may even melt such commodity money to derive pure gold and silver.
They would then sell it at the market price, as it is higher than the rate fixed by the government.

The law came into play most recently during the economic crisis in Sri Lanka last year.
The Sri Lankan central bank fixed the exchange rate between the Sri Lankan rupee and the U.S. dollar.

The law holds true only when the exchange rate between currencies is fixed by the government and it is implemented effectively by authorities.
In the absence of any government decree fixing the exchange rate between currencies, it is good money that eventually drives bad money out of the market.
This phenomenon wherein “good money drives out bad” is called Thiers’ law and it is seen as a complement to Gresham’s law.
The recent rise of private cryptocurrencies is cited as an example of good money issued by private money producers driving out bad money issued by governments.