Gresham’s Law: What Happens When Governments Fix Currency Exchange Rates

Relevance: GS3 - Effects of liberalization on the economy, Indian Economy, and issues relating to planning, mobilization, of resources, growth, development, and employment.

(Source: The Hindu, 09/12/2023)

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Why in the news?

• This article discusses Gresham’s Law, which comes into play when the exchange rate between two currencies is fixed by the government at a certain ratio which is different from the market exchange rate.
• This was recently applied in Sri Lanka where the Sri Lankan Central Bank fixed the exchange rate between the Sri Lankan Rupee and the U.S. dollar.

What is Gresham’s Law?

• According to Gresham’s Law, “bad money drives out good money.”
• It becomes relevant when a government sets an exchange rate for its currency that differs from the market exchange rate.
• As a result of this government intervention, a disparity occurs between the official rate and the actual market value.
• The currency that the government undervalues, fixing its price below the market rate, tends to disappear from circulation while the overvalued currency remains in circulation but struggles to find buyers.
• Conditions for Gresham’s Law to be applicable:
• Government Intervention: Gresham's Law is applicable only when governments enforce fixed exchange rates and the law is implemented effectively by authorities.

Market Exchange Rate Dynamics

Equilibrium Price

• The market exchange rate is an equilibrium price at which the currency supply equals demand.
• Currency supply rises with price, and demand falls as price increases.
• This results in the creation of a dynamic balance.

Consequences of Price Fixing

• When the Government imposes a cap on the price of a currency, this equilibrium is disrupted.
• The undervalued currency's demand rises when its price is fixed low, while supply diminishes, leading to a currency shortage.

Origins of the term

• Gresham's Law is named after Thomas Gresham, an English financier who advised the monarchy on financial matters.
• It applies to paper currencies as well as commodity currencies and other goods.
• Whenever a government arbitrarily fixes the price of a commodity, making it undervalued compared to the market rate, the commodity vanishes from the formal market, driving transactions into the black market.
• Sometimes, it can result in the outflow of certain goods through the borders.
• E.g.:
  • Gresham's Law comes into play when governments fix the exchange rate of commodity money, like gold and silver coins, below their market value.
  • This results in people stopping using these coins at the government-fixed rate.
  • Therefore, people opt to melt them and sell the pure metal at a higher market price.

Case Study: Sri Lanka's Currency Crisis

• During the Sri Lankan economic crisis, the Sri Lankan Central Bank fixed the exchange rate between the Sri Lankan rupee and the U.S. dollar.
• It was mandated that the price of the U.S. dollar in terms of the Sri Lankan rupee should not rise beyond 200 rupees per dollar even though rates in the black market suggested it should be much more.
  • People were prohibited from paying more resulting in the Sri Lankan rupee becoming overvalued and the U.S. dollar becoming undervalued in comparison to the market exchange rate.
• As the official rate constrained the dollar's price, it gradually disappeared from the formal foreign exchange market forcing people to rely on the black market where it was available at a higher than official rate.

Thiers’ Law

• In the absence of government-mandated rates, Thiers' Law, which is a complement to Gresham’s Law, comes into play.
  • It has been named after the French politician Adolphe Thiers.
• According to Thiers’ Law, good money drives out bad money in the absence of a government decree fixing the exchange rate between currencies.
• In case the exchange rate between currencies is not fixed and people have the choice to freely choose between currencies, they will gradually stop using currencies that they consider to be of poor quality and adopt currencies that are found to be of better quality.
• The rise of private cryptocurrencies in recent years has been cited by many analysts as an example of good money issued by private money producers driving out bad money issued by governments.

Conclusion

Gresham's Law highlights the consequences of government interference in exchange rates.

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FAQs

MCQs

Question: Consider the following statements:

1. Tight monetary policy of the US Federal Reserve could lead to capital flight.
2. Capital flight may increase the interest cost of firms with existing External Commercial Borrowings (ECBs).
3. Devaluation of domestic currency decreases the currency risk associated with ECBS.

Which of the statements given above are correct? (UPSC CSE 2021)

(a) 1 and 2 only

(b) 2 and 3 only

(c) 1 and 3 only

(d) 1, 2 and 3

Question: Consider the following liquid assets:

1. Demand deposits with the banks
2. Time deposits with the banks
3. Savings deposits with the bank
4. Currency

The correct sequence of these decreasing order of Liquidity is (UPSC CSE 2013)

(a) 1-4-3-2

(b) 4-3-2-1

(c) 2-3-1-4

(d) 4-1-3-2