What happens when governments fix currency exchange rates, according to Gresham’s Law?

  • The rule, named after English financier Thomas Gresham, was most recently used amid Sri Lanka’s economic crisis last year.
  • The Sri Lankan Central Bank has set the exchange rate between the Sri Lankan rupee and the US dollar.

Concerning Gresham’s Law

  • Gresham, Thomas: The statute is named after Thomas Gresham, an English financier who provided financial advice to the English crown. It is applicable to commodity currencies as well as numerous items in addition to paper currencies.
  • Bad money attracts good money: This adage exemplifies a phenomena that occurs when government-fixed exchange rates deviate from market exchange rates, resulting in the withdrawal of devalued money from circulation.
  • Gresham’s Law applies when governments arbitrarily fix prices, causing a commodity to become undervalued in comparison to its market exchange rate. Because of this undervaluation, the commodity is driven out of the formal market.
  • Black Market: Because the undervalued commodity is no longer available through official channels, the only option to obtain it is through the black market.
  • Goods Outflow: When a country’s prices are forced reduced by the government, certain goods may leave the country.

Commodity Money Application

  • Gresham’s Law is especially visible when a government fixes the exchange rate of commodity money, such as gold and silver coins, substantially below their market value. People may hoard or melt these coins in response to gain their intrinsic value, which is more than the government-set rate.

Recent Case Study in Sri Lanka

  • Sri Lankan Economic Crisis: Gresham’s Law was observed during the Sri Lankan economic crisis, when the central bank regulated the exchange rate between the Sri Lankan rupee and the United States dollar.
  • Overvaluation of the rupee: The government stipulated that the price of the US dollar not exceed 200 Sri Lankan rupees, despite the fact that the black market rate suggested a greater value. The rupee’s overvaluation reduced the availability of dollars and forced the US currency out of the formal foreign exchange market.
  • Individuals seeking US dollars for foreign transactions were forced to buy them on the illegal market at rates that exceeded 200 Sri Lankan rupees per dollar.

Gresham’s Law Conditions for Applying

  • Government-Imposed Fixed Rates: Gresham’s Law is in effect when government officials set and enforce fixed exchange rates between currencies.
  • Effective Enforcement: Effective enforcement of these rates by authorities is required for the law to be effective.

Concept of antithesis: Thiers’ Rule

  • “Good Money Drives Out Bad” The opposite phenomena occurs in the absence of government-imposed currency rate fixes. People tend to forsake lower-quality currencies in favour of higher-quality ones, resulting in the domination of “good money.”
  • Thiers’ Rule: Thiers’ Law, named for French politician Adolphe Thiers, is a principle that supplements Gresham’s Law.
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