In India's informal economy, Gresham's Law is relevant because fake money and low-quality coins often mix with real currency, affecting the overall value of money in circulation.
What is Gresham’s law?
Gresham’s law refers to the dictum that “bad money drives out good.”
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.
Gresham’s law is named after English financier Thomas Gresham who advised the English monarchy on financial matters.
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.
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.
In India, there is one-rupee note and one-rupee coin.
Both are forms of legally good money. Yet, the public sometimes prefer one form of a particular denomination to another, e.g., they may prefer the paper note to the rupee note.
If there is such a preference for one form of money rather than another, it is an example of Gresham’s Law in operation.