Gresham’s law in action in Sri Lanka

Gresham’s law in action in Sri Lanka

Subject :Economy

Section: External Sector

Context: The economic theory of Grisham’s law is being seen in action after Sri Lanka fixed exchange rate in dollar.

Key Points:

• Gresham’s law refers to the dictum that “bad money drives out good.” Gresham’s 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.
• 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.
• What happens when exchange rate is fixed at a rate above 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.
  • 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 applies not just to paper currencies but also to commodity currencies and other goods.
•  In fact, whenever the price of any commodity — whether it is used as money or not — is fixed arbitrarily such that it becomes undervalued when compared to the market exchange rate, this 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.
•  They may even melt commodity money to derive pure gold and silver that they can sell at the market price, which is higher than the rate fixed by the government
• What happened in Sri Lanka?
  • The law came into play most recently during the economic crisis in Sri Lanka last year, during which the Sri Lankan central bank fixed the exchange rate between the Sri Lankan rupee and the U.S. dollar.
  • The Central Bank of Sri Lanka, at a certain point, mandated that the price of the U.S. dollar in terms of the Sri Lankan rupee should not rise beyond 200 rupees per dollar.
  • In effect, people were banned from paying more than 200 Sri Lankan rupees for a dollar, thus causing the rupee to be overvalued and the U.S. dollar to be undervalued when compared to the market exchange rate.
  • This caused the supply of dollars in the market to fall and the U.S. dollar to be gradually dla1riven out of the formal foreign exchange market.
  • People who wanted U.S. dollars to purchase foreign goods then had to purchase dollars from the black market by paying far more than 200 Sri Lankan rupees for each U.S. dollar

Conditions for the Grisham’s law to work:

1. Gresham’s law, however, holds true only when the exchange rate between currencies is fixed under law by the government and
2. the law is implemented effectively by authorities.

Why implementation of the rate is necessary?

• 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 and not the other way round.
• When the exchange rate between currencies is not fixed and people have the choice to freely choose between currencies, people gradually stop using currencies that they consider to be of poor quality and adopt currencies that are found to be of better quality.
• This phenomenon wherein “good money drives out bad” is called Thiers’ law (named after French politician Adolphe Thiers) and it is seen as a complement to Gresham’s law.
• 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