Gresham's Law and the Modern Theory of the Demand for Money

Author(s): Dennis O. Flynn and Don Roper

Source: Eastern Economic Journal, Vol. 8, No. 3 (Jul., 1982), pp. 219-235
Published by: Palgrave Macmillan Journals
Stable URL: https://www.jstor.org/stable/40324821
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Eastern Economic Journal, Vol. VIII, No. 3, July 1982

Gresham's Law and the Modern

Theory of the Demand for Money
DENNIS O. FLYNN and DON ROPER*

I. Introduction currency debate or "battle of the standards,"

Gresham's Law - the observation that good that Gresham's Law became widely dis-
(undervalued) money tends to be driven from cussed. Henry MacLeod (1858) is responsible
circulation by bad (overvalued) money - is for proclaiming the idea a "law" and naming
believed to have been stated, in one form or it after Gresham, and Stanley Jevons (1875)
another, since the time of ancient Greece.1 did much to popularize the doctrine. In the
Early statements of what later became known last quarter of the 19th century it was a
as Gresham's Law were concerned with the popular dictum among monometallists with
which to counter the arguments of bimetallists
problems caused by wear, clipping, or debase-
and silverites. When the wind was taken from
ment of coinage. Although the Law was origi-
nally attributed to Sir Thomas Gresham, the inflationists' sails by the gold discoveries
based on his correspondence with Queen Eli- of the 1 890s, Gresham's Law tended to take a
backseat in the development of monetary
zabeth in 1558, Frank W. Fetter (1932) has
thought.
argued that it is doubtful whether any state-
ment of Gresham's Law can be found in Gresham's Law is a historical observation

Gresham's writings.2 which requires a theoretical explanation. It

It was in the last part of the 19th century,might not be surprising that explanations of
during the period of deflation and the fiercethe Law developed in the late 19th century,
and repeated in the early 20th century, have
Department of Economics University of the Pacific
shortcomings when viewed from the perspec-
Stockton, CA. 95211, and Department of Economics
University of Utah Salt Lake City, Utah 841 12 tive of modern theory. The purpose of this
essay is to reconsider the theory needed to
♦The authors have benefited from comments by Rich-
ard Fowles, Lance Girton, Charles Peake, Laurence
explain Gresham's Law. We argue that the
Phillips, Jim Rock, Lori Warner, and Richard Winkel-
most common 19th century explanation of
man. An earlier version of this paper was presented at the
Sixth Annual History of Economic Society ConferenceGresham's
in Law is incapable of accounting for
1979.
the phenomena it was designed to explain.
'In the literature on Gresham's Law, a passage from
Aristophanes' (5th century B.C.) is widely cited. Our argument is based, not on a small point in
Although MacLeod (1858) coined the term, he later recent monetary theory, but on the basic
(1892) recognized that Orêsme and Copernicus made conception of the demand for money. An
similar observations. Translations of statements by the
latter two are in Horace White (1895, pp. 466-7). adequate explanation of GL (Gresham's Law)
2In a letter by Gresham in 1 558, there are references to requires the modern treatment of the DM
gold and silver coins which MacLeod regarded as a (demand for money) as an asset to hold.3
statement of the Law. Fetter (1932) argued that this
letter does not contain a statement of the Law and that,
perhaps a statement that comes closest to the principal, is 3Four acronyms will be used in the paper. It might be
a discussion in Queen Elizabeth's proclamation of 1 560. useful to list them here: DM (demand for money), GL
Gresham's writings are found in Raymond de Roover (Gresham's Law), BOP (balance of payments), MABP
(1949), who agrees with Fetter's position. (monetary approach to the BOP).

219

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220 EASTERN ECONOMIC JOURNAL

In the next section an essential feature of modern literature the DM is treated as the
the modern theory of the DM is contrasteddemand for an asset to hold and, as such, it is a
with a different concept which is referred to asstock concept.5 In this section we contrast the
the "demand for money" in many writings bytwo versions of the DM, present some repre-
19th century monetary economists. The stocksentative examples of earlier thinking, and
nature of the modern DM is shown to be show why the newer version is essential to an
important for explaining why good money explanation
is of GL.
removed from circulation and what quantityThe is earlier concept of money-demand as
used by many 19th and some early 20th
removed. In Section III 19th century and
early 20th century explanations of GLcentury
are economists can be defined as the sum
shown to be inadequate whenever the stock
of all things sold for money. By this definition,
the sale of anything for money is the seller's
concept of the demand for money is absent.
DM. The sale of labor services and IOUs
In the last part of the paper the "bad"
(consumer and mortgage debt) by households
money driven from circulation in GL is shown
constitutes much of their money demand. The
to be analytically similar to, in modern times,
a loss of international reserves (balance ofof (intermediate and final) goods by firms
sale
and the issuance of corporate debt is money
payments deficit) following an overly expan-
demand by firms. This concept is clearly a
sionary monetary policy. Since the stock con-
flow - the annual rate of money-demand is
ception of the DM is the heart of the modern
MABP (monetary approach to the balance twelve
of times money-demand per month. If
payments) while "bad" money driven from every increase in cash balances is summed
circulations is akin to a BOP deficit, the over all economic agents, the result is the
theory of G L is strikingly similar to the aggregate flow-DM.
MABP. Or, stated another way, the monetary The modern DM can be defined as the
approach to the balance of payments provides average inventory of cash balances that an
a theoretical framework for explaining Gre- economic agent desires to maintain.6 When a
sham's Law. firm issues debt to finance investment in capi-
tal equipment, its flow-DM rises but its stock-
II. Conceptions of Money-Demand and the
Operation of Gresham's Law
output) as a statement, not of the DM, but of aggregate
No attempt is made here to presentcommodity
a demand, which has (since the Keynesian
Revolution) usually been expressed as C + / + G. If,
comprehensive account of the evolution of the
following this line of argument, MV is identical to C +
demand-for-money concept. But it should be/ + G, V might depend inversely on interest rates (as does
clear from the examples cited below thatinvestment)
a rather than positively on interest rates (as
does the reciprocal of money-demand).
change has taken place over the last century.
5D.H. Robertson (1922) characterized the DM con-
In the 19th and early 20th centuries some
cepts as "money on the wing" and "money sitting." The
authors used the phrase, "demand for money"
distinction is frequently found in discussions of the trans-
to refer to a concept that we call, a "flow-
actions versus the Cambridge approach to the quantity
theory. See, for example, Eshag ( 1 963), Friedman ( 1 968)
DM." Other authors avoided using the ( 1 970), and Keynes ( 1 930, ch. 1 4).
phrase, "demand for money," altogether.4 In 6Theoretical work on the transactions DM by William
Baumöl (1952) and James Tobin (1956) characterizes
4Many readers will be quick to point out that the the DM as the average inventoryof money, and this is
DM is
captured by velocity. Although it is unquestionably what
truewe are calling the "stock-DM" for purposes of
that in the modern quantity theory V is regardedcontrast.
as The flow-DM, as used here, is not the time-
demand determined, some writers [e.g., Mill (1848, book
derivative of the stock DM. It is the sum of gross receipts
III, ch. 8), Keynes (1936, ch. 21) and (1979, ch.
of 4)]
money over time or the rate of gross receipts at a point
regarded the left-hand side of MV = Py (where yinistime.
real

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 GRESHAM'S LAW AND THE MODERN THEORY OF THE DEMAND FOR MONEY 221

Occurence of a shift from the flow version

DM does not. The firm must go through
money, via issuance of IOUs, to obtain equip-
to the stock view of the demand for money is
ment, but the average inventory ofindicated in a classic
cash that it article by Edwin Cannan
desires to maintain increases little (1921,
if anyp. 4).as
Toaemphasize the distinction
result of the decision to issue debt.
between the two concepts of the DM, he posed
The flow DM can be seen as an application an analogy between the demand for money
of the kind of demand and supply analysis and the demand for houses:
associated with non-durable commodities that
. . .we must think of the demand for currency as
are treated as flows. The stock-DM, by con- being furnished, not by the number or amount of
trast, brings the demand for money into line transactions, but by the ability and willingness of
with the demand for durables or for other persons to hold currency, in the same way as we
think of demand for houses as coming not from the
financial assets, both of which are stock con-
persons who buy and re-sell and lease and sub-lease
cepts.
houses, but from the persons who occupy houses.
Having defined two versions of money- Mere activity in the house market - mere buying
demand, our next task is to show that the flow and selling of houses - may in a sense be said to
concept of the DM was held by some eminent involve "increase of demand" for houses, but in the
economists during the time that GL was given corresponding sense it may be said to involve an
equal "increase of supply"; the two things cancel.
so much attention in public discussion. In the
The demand which is important for our purposes is
late 1 9th century, probably the most eminent
the demand for occupation. In the same way, more
American authority in monetary economics transactions for money - more purchases and sales
was Francis A. Walker. In his authoritative of commodities and services - may in a sense be
said to involve increase of demand for money, but
work, Money, Walker ( 1 878, p. 63) wrote that
in the corresponding sense it may be said to involve
"the question as to the demand for money [is]
an equal increase of supply of money; the two
merely the question [of] what goods are things cancel. The demand which is important for
offered for money." This same view is found our
in purpose is the demand for currency, not to pay
Kemmerer (1906, pp. 13-28). A more com- away again immediately, but to hold. Just as you
plete statement of the idea can be found are
in a less important demander of houses if you
John Stuart Mill: occupy a £1000 house than if you occupy a £2000
house, so you are a less important demander of
The demand for money, again, consists of all goods currency if you keep on the average £5 in your
offered for sale. Every seller of goods is a buyer of pocket than if you keep £10.
money, and the goods he brings with him constitute
his demand. ... It is indifferent whether, in charac- These citations indicate that a flow concep-
terizing the phenomena, we speak of the demand tion of the DM was prevalent at the turn of the
and supply of goods, or the supply and demand for century and that this concept is fundamen-
money. They are equivalent expressions. [(1848, p. tally different than the modern stock concept.
1 1) or (1909, p. 491)]
The difference between the two concepts has
Although Fisher ( 1 9 1 1 ) did not use the phrase also been pointed out by Milton Friedman
"demand for money," the right-hand side of
his equation, MV = PT, is an algebraic state- Mill's) quantity theory with Fisher's neoclassical version
ment of the flow-DM, viz., the value of all of the quantity theory. We are also classifying Mill and
Fisher together, but not in their use of time. We recog-
items offered for sale to obtain money per unit
nize, following Mason, that Fisher's statement of the
of time.7 quantity theory was for the long-run (a "run" sufficiently
long for the lapse of his "transition period") whereas
7Will Mason (1976) has objected to Arthur Marget's many classical monetary economists used the quantity
(1938, vol. 2, p. 105, n. 36) reference to the '"stream' theory only as short-run doctrine. It is nevertheless possi-
formulation of the Mill-Newcomb-Fisher Type [of mone- ble to represent the flow-DM at a point in time with
tary analysis]" because it tends to equate classical (e.g., Fisher's PT.

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222 EASTERN ECONOMIC JOURNAL

specialPatinkin
(1970). As indicated by case. As will be shown below, the
(1972), the
stock-DM isto
flow concept continued essential
beforused
determining
in the
whether
United States until the the demonetization
Keynesian of good money is
Revolution.
But the stock conception
equal to theof money-demand
introduction of bad money.
To show the role
was prevalent at Cambridge in of the
the stock-DM,
late it isnine-
useful toEshag
teenth century. Eprime construct a (1963)
simple model pointed
of Gre-
sham's Law.
out that it can be found in The model useswritings
early the same frame- of
Alfred Marshall (1887).
work of analysis which is the hall-mark of the
monetary approach
Our next task is to show why to the BOP
the [see, for
modern
example, Johnson (1972)]. Itis
stock conception of money-demand is arequired
simplified
version of the MABPof
in any adequate explanation since we abstract from
Gresham's
Law.8 It is useful to begin
the banking
with
system. Money
a representa-
is composed of a
"good" money, say,
tive statement of Gresham's gold (G)According
Law. and a "base" or
bad money
to Ralph Hawtrey (1923, (B).9 In179-80):
pp. symbols, M = Par -G + B
where Par represents the gold parity, the price
The increase in the circulating medium causes, in
of gold (in terms of the monetary unit) fixed
accordance with the quantity theory, a depreciation
of the monetary unit andby theamonetary
general authority.10
riseMonetary equi-
of prices.
librium can
This general rise of prices be expressedbut
would, as M/Pfor
= Lor Par«
the
bimetallic system, affect
G +the
B = PL less
where Lplentiful metal as
represents the stock-DM
much as other commodities, butIfas
in real terms. soon
we restrict ouras thetoprice
attention the
of this metal as bullion rises appreciably above its
price as the coins begin to be melted down or
long-run rather than the short-run and to
exported. non-hyperinflationary situations, the explana-
tory power of interest rates in the determina-
The monetization of "bad" money or paper tion of L is small compared to real income or
money will, according to the quantity theory wealth. Secular changes in real income and,
and as Hawtrey says, raise prices and this will
cause some of the internationally acceptable
9As late as the turn of this century, the term "base
money, say, gold, to be exported or melted. money" meant bad or debased money ([e.g., Breckinridge
But how much gold is displaced from domestic (1903)]. This should not be confused with the modern
circulation? The usual view is given by Simon terminology which uses "base money" for central bank
liabilities.
Newcomb:
l0The institutional arrangements underlying the deter-
mination of the price of gold at parity differ depending on
The equilibrium will be reached when the gold
whether the public holds gold coins or gold certificates
eliminated from the circulation is equal to the
convertible into gold. If the domestic currency price of
paper money which has been added. (1885, p. 413)
gold bullion is tending to rise above Par, either the cullers
of good coin will take gold coins to the bullion market or
This conclusion is an interesting but very
the public will take gold certificates to the government in
exchange for gold which is then taken to the bullion
8A distinction needs to be made between two different market. Both cases have the same economic effect - they
historical experiences which GL has been used to keep the price of gold builion from going above Par and
describe. One situation concerns a limited or governmentcause a dimunition of money. We will focus on the latter
controlled introduction of "inferior" money. Thiscase, but the analysis is fundamentally unaltered if we
occurred in debasements and, for example, with the were to consider the case of gold coin or some combination
limited monetization of silver money under the Bland- of gold coin and gojd certificates.
Allison Act of 1 878. A second situation concerns bimetal-Since the model will not concern gold flows between
lism. In a bimetallic standard, the quantity of "cheap"countires, it can be regarded as applying to all gold
money introduced is market determined. In order to countries on the gold standard taken together.
explain the change in the composition of the circulating The definition of M as Par-(/ + B is true only if Par
medium in either case requires a stock conception of thehas never changed. A more general definition of M would
DM. The model in the text centers around the first use of replace Par- G with the integral from minus infinity to the
GL for simplicity. present of Par(f) . G\t)dt.

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 GRESHAM'S LAW AND THE MODERN THEORY OF THE DEMAND FOR MONEY 223

value
therefore, L, will be taken as exogenous of the physical material used in the
in our
analysis. fiduciary money, viz., the paper. The market
The theory of GL tends to reverse theratio is, therefore, nearly infinite when one
order
money
of causation associated with the quantity the-is 100% fiduciary and the other has
ory of money. Rather than focusing metallic
on the content. The "mint ratio" is easily
computed in this case as the official parity
influence of M on P, G L takes P as (approxi-
mately) determined outside the system value of
andgold divided by 1.0, the monetary
focuses on the influence of P (or its determi-
value of the monetary unit. Since the disparity
nants) on (the composition of) M. If authori-
between the market and mint ratios is so great
ties keep the money price of gold bullionin this case, it is obvious which is the "good"
fixed
money
at a value Par, the real value of gold, R, can bewithout resort to these categories.
expressed as R = Par/P. If, and we willWhat we have done is to show that the catego-
return
ries of
to this question below, the long-run value ofmint
R and market ratios can still be used
were independent of domestic money to distinguish
and between good and bad monies
when oneas
prices, P would be completely determined currency is 1 00% fiduciary. But the
categories
P = Par//?. Substituting this solution for Pare not as important as they are
under awe
into the monetary equilibrium equation bimetalic system since it is already
obtain obvious that the fiduciary money is the base
money. The good/bad distinction is already
Par.G = (Par//?).L- B. (1)
assumed in our model; consequently, the
stock-DM (L) plays no role in determining
This presents G as the endogenous variable
which currency is removed from circulation.
which is determined by R, L (or real income),
and /?, given the value of parity. There are
In order for equation ( 1 ) to be used alone to
several issues that must be faced if equation
explain the amount of gold (G) in the mone-
tary system, R must be autonomous to G. One
( 1 ) is to be regarded as useful to help explain
GL. particularly interesting case is the classical
Consider, first, the definition of "good" condition of constant costs. One can imagine,
versus "bad" money. The traditional criterion for example, a linear production frontier
is based on the comparison of the mint ratio to between gold and all other commodities with a
the market ratio. The mint ratio is the ratio of slope of (minus) R. This could be used as a
the two parities (e.g., the official dollar price long-run model which implies that the goods
of gold divided by the official dollar price of value of gold is determined independently of
silver) and the market ratio is the market demand conditions. In order for R to be
value of one bullion divided by the market treated as constant in the long-run, of course,
value of the other bullion.11 These ratios do we have to assume that the slope of the
not appear in the model explicitly since the production frontier is unaffected by techno-
base money being considered is assumed logical change.12 In this case,
100% fiduciary. In this limiting case the
- ÒG = ÔB/P2LT - ÔL/R (2)
"market ratio" can be computed as the mar-
ket value of gold bullion divided by the market where bB is the net increase in base money. A

"If there is no seigniorage charge such that both coins

are full-bodied, the market ratio can not deviate from the
mint ratio (by more than some transactions costs) as long
as both monies are in circulation. A more general defini-
tion of the market ratio is the ratio of prices that would
clear the gold and silver bullion markets in the absence of
the melting of either coin and the coining of either metal.
l2The discussion in the text is alluding to the kind of
barter model used in international trade theory which is
supposed to be a long run model. Some of the immense
changes that technological change have caused in R over
centuries are discussed by Flynn (1981) and Miskimin
(1977).

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 224 EASTERN ECONOMIC JOURNAL

... to one million

net increase in G means that sterling,gold
that sum being
is then
mone
sufficient
tized; therefore, - òG isforthe
circulatingvolume
the whole annual produce
of gol
of their land and labour. Let us suppose too ...
demonetized. This equation addresses the ear-
bankers issued [800,000] promissory notes . . . The
lier question of whether the ifvolume
channel of circulation, of
I may be allowed such an gol
demonetized exactly offsets
expression, will remain the volume
precisely the same as o
base money introduced. In the
before. One million case
we have supposed of tocon-
sufficient
fill that channel.
stant costs, the answer is Whatever,
'yes'therefore,
only is poured
if th
into it beyond this sum, cannot run in it, but must
demand for money has not
overflow . . . Gold changed - if
and silver ... to the amount of ÒL =
0.
eight hundred thousand pounds will be sent abroad
Even if the costs of production in gold . . . (Wealth of Nations, Cannan edition, 1937, pp.
mining were not constant, R may still be 277-8)
independent of the amount of gold absorbed in
the monetary system (ÒG). The flow demand Some writers recognized that good money
for gold as a commodity and the flow supply of would not be displaced by the introduction of
gold from mining should exercise a dominance bad money unless the total quantity exceeded
over R in the long run.13 In the short-run, the stock demand. A sample of statements
however, the amount of gold demonetized and from such writers is the following:14
sold on the bullion market should affect R
In point of fact, also, good and bad coins will
such that R and G interact in a simultaneous
circulate together in a given country as if they were
manner. But the longer the time period, the
all good when the circulation itself is not in excess
more R can be taken as independent of G and,
of the demand for it. (Giffen, 1 89 1 , p. 304)
therefore, an independent determinant of the
volume of gold coin or gold backed money. Should the silver coins be insufficient to fill the
circulation, some gold money would remain in use.
The special result, that the displaced money
(Laughlin, 1903, p. 429)
is equal in value to the introduction of inferior
money, was stated in the preceding quote from
Newcomb. Adam Smith obtained this result We thus find, as a limitation of Gresham's law, the
by using a metaphor, the "fullness" of thecondition that the aggregate of good and bad coins
must be in excess of the country's need for circulat-
"channels" of circulation, which served the
ing medium. (David Kinley, 1904, p. 54)
role of a stock-DM:

Let us suppose, for example, that the whole circu- ... if there is not too much of the bad money it is
lating money of some particular country amounted just as good as the good money. (Frank A. Fetter
l3Models of the gold standard in which the long-run
domestic price level is determined independently of the
domestic quantity of money have been developed by
Barro (1979) and by Roper and Warner (1981). The
"long-run" over which GL has been thought to operate
can be as short as a few years (as when silver was driven
from circulation in the United States after gold was
revalued from 15 to 16 in 1834 or as long as several
centuries [Watson (1967)].
The model concerns the removal of good money only
through its transformation into bullion. The other avenue
for the elimination of good money is through exportation.
Good or internationally acceptable money was exported
when the exchange rate between two countries' monies
deviated from the ratio of their parities by more than the
cost of shipping and insurance. The stock-DM plays the
same role in this process as it does for the melting of good
coins.
1905, p. 447)
When the authors conclude that the volume of
good money displaced might not equal the
volume of bad money introduced, they had
some, at least implicit, conception of a stock-
DM even if they do not call it the "demand for
money."
l4Although Marshall (1923) did not, to our knowledge,
explicitly employ the Cambridge DM concept to explain
GL, he did employ analogies based on stock concepts.
Other writers who, at least implicitly recognized the need
for a stock DM include Frederick Bradford (1928, p. 89),
J.F. Johnson (1905, p. 195), James Magee (1926, p. 65),
Taussig (191 1, p. 269), and J.R. Turner (1919, p. 255).

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 GRESHAM'S LAW AND THE MODERN THEORY OF THE DEMAND FOR MONEY 225

III. The Flow-Explanation of Gresham's

tionLaw
of the passage from Mill:

This section examines an explanation But

of money
GL hoarded does not act on prices. Money
given by earlier economists who did not
kept in reserve by individuals to meet contingencies
employ a stock conception of the which
DM. do Tonot occur, does not act on prices. The
money in the coffers of the Bank, or retained as a
understand this explanation of GL, we need to
reserve by private bankers, does not act on prices
consider a central concept - the distinction
until drawn out, nor even then unless drawn out to
between hoarded and circulating money - in on commodities.
be expended
their general theory of aggregate demand and
Economists such as Mill and Walker natu-
price level determination.
rally approached GL with these categories of
Classical monetary theory gave the quan-
circulating versus hoarded money. To relate
tity of money a crucial role in determining the
GL to their theory they had to argue that the
price level or, its reciprocal, the value of
base or light coins fit their theoretical cate-
money. But early statements of the quantity
gory of circulating money and that the good
theory frequently distinguished between
coins fit their category of non-circulating or
money which is circulating and money which
is hoarded. This distinction is evident in the hoarded money. Since the hoarding/spending
decision is made by the buyer, not the seller,
following passage from Mill [(1848, p. 19) or
GL must, in order to be explained by their
(1909, p. 496)]:
theory, be the result of the behavior of buyers.
Whatever may be the quantity of money in the In other words, if the good coins are to be
country, only that part of it will affect prices whichhoarded and the bad coins are to be spent, the
goes into the market of commodities, and is there
driving force behind Gresham's Law must be
actually exchanged against goods. Whatever
increases the amount of this portion of the money inthe decisions of purchasers. This view of the
the country, tends to raise prices. relation between GL and the behavior of
spenders or buyers is reflected in the following
The money that is "actually exchanged passages:16
against goods" or the flow of money which
appears in markets as a demand for goods and ... the principle of Gresham's Law begins at once
services is not the stock of money, A/, but theto operate, acting through the desire of men to pay
their debts, or effect their purchases, with the least
product of M and income velocity, viz., A/K.15valuable commodity which will answer the require-
Non-circulating or, what was called ments of exchange. (Walker, 1878, p. 1945)
"hoarded" money, was thought to have no
impact on prices, as indicated in the continua-They want coin, not to keep it in their own pockets,
but to pass it off into their neighbor's pockets; and
15The hoarding/circulating distinction can be seen as a the worse the money which they can get their
special case of the use of the velocity concept. Hoarded neighbor's (sic) to accept, the greater the profit to
money has a zero velocity and circulating money has a themselves. (Jevons, 1875, p. 81)
positive velocity. The hoarding/circulating distinction
was superceded by the more general notion that some
money has a higher velocity than other money. Newcomb
The reason the cheaper of two moneys always
(1885) was one of the first writers to develop the mone- prevails is that the choice of the use of money rests
tary demand for goods and services as the product of the chiefly with the man who gives it in exchange, not
stock of money and its rapidity of circulation. In post- with the man who receives it. (Fisher, 1911, p.
WWII notation, Newcomb's equation is MV = Py. The 113)
formal use of the equation of exchange became more
widespread as a result of Fisher's work (1911) although
Fisher shifted from Newcomb's income velocity or ra- The "driving out" under Gresham's law is ...
pidity of circulation (Py/M) to, what we now call, trans-
actions velocity (PT/M). But regardless of the kind of 16Similar statements can be found in William Brough
velocity used, these writers did not emphasize the demand ( 1 896), p. 29), William Scott ( 1 9 1 9, p. 27), L. A. Ruefner
for money to hold. ( 1 927, p. 500), and D. Kinley ( 1 904, p. 54).

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226 EASTERN ECONOMIC JOURNAL

dependent upon the existence ofis to

or debtor's option a be
payer's or deb-
of any consequence,
tor's option. (Fetter, 1932, p. 493).
the government or Crown must also require
that seller or creditor not charge different
Suppose you have two $1 bills, the one old, dirty
prices or interest rates. This requires that
and greasy, and the other, brand-new and crisp,
legal-tender laws be accompanied by price
and you are called upon to pay out one of them.
and interest
You pay out the old one; rate controls. As noted
everybody does, by Mis-every
kimin (1972), attempts
time. It goes back into circulation andby the Crown
the crispto new
note remains as long as possible
impose in
price controls in the someone's
late medieval
pocket. That's Gresham's Law . . . (Arthur Faubel,
period were difficult to enforce. In later times,
1932, p. 156)
as in 1862 with the passage of the Legal
Tender Act regarding the issuance of Green-
When it is a question of keeping it for ourselves we
prefer good money, but when it is a question of backs in the U.S. Civil War, the legal-tender
giving it to a tradesman or to our creditors, why acts were not accompanied by price controls.
give good money if bad will do equally well, i.e., if it If we accept the view that legal-tender laws
cannot be refused in payment? And this is the have usually been accompanied by ineffective
hypothesis on which Gresham's law rests. (Charles
price controls or by no price controls, then the
Gide, 1913, p. 298)
role of legal-tender laws in the operation of
GL must be derived from another source.
Legal Tender Laws in the Flow Explanation
To determine how legal tender laws are
A theory which relies on the preferences of related to GL, we must recognize their impli-
the spender and ignores the seller is suspect cations for the behavior of government
because the typical economic agent is, on the authorities. If the government or Crown pro-
average, receiving money as often as spending claims that two monies are equivalent for
money. Why should the preferences of the public debts, this is important inasmuch as it
same person, as a buyer, be important and, as implies that the government or Crown readily
a seller, be unimportant? As the preceding accepts either money for taxes and customs
quote from Gide suggests, this asymmetry was duties. If the government accepts base money
justified on the gound that legal-tender laws which, by weight, is worth less than full-
give the choice of currency to the buyer, not bodied money, this tends to support the value
the seller. Thus, legal-tender laws seemed to of base money in terms of full-bodied money.
dovetail nicely with the monetary theory In other words, a seller of goods in the private
based on the decision of the buyer to circulate sector is not obligated to accept the inferior
or to hoard money. money at parity with good money but would
It is necessary to inquire exactly how legal- be more willing to not discount the inferior
tender laws make the choice of currency a money because it can be used to discharge
buyer's option. The most crucial point to note taxes or government duties. The greater their
is that, if the seller (or a new creditor) can volume, the less likely inferior money is to
charge different prices (or different interest circulate at a discount anywhere in the econo-
rates) depending on the currency used by the my.18
buyer (or debtor), then the choice of currency
will be a matter of indifference.17 If a buyer's is executed. It is not the medium in which creditors are
paid but how much of any particular medium they are
l7Newly enacted legal-tender laws sometimes redistrib- paid that matters. As great as the implications might be
ute wealth on pre-existing private debt, but this impa'ct for pre-existing debt, legal tender laws do not force the
does not force the operation of GL. Litigation over expulsion of good money through this route.
whether a private contract has been fulfilled or not This same conclusion has been reached by Miskimin
concerns the unit of contract, not the medium in which it ( 1 972) on historical grounds.

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 GRESHAM'S LAW AND THE MODERN THEORY OF THE DEMAND FOR MONEY 227

In order for GL to operate, the two monies

If the flow explanation of GL were correc
have historically had to circulate byittale (in be necessary for the typical buyer
would
earlier language) or at parity (in last century's
be able to distinguish between light and hea
coins.(in
language) or at a fixed rate of exchange Advocates of (what we call) the fl
explanation
modern language).19 Legal tender laws, as we of GL implicitly recognized
problem with their explanation when the
have argued, assured that monies of different
weights would circulate by tale or nominal
recognized that not everyone can detect a
act on the
value by making it possible for sellers to difference between the heavier and
accept intrinsically inferior moneylighter
without
coins:20
fear of loss.
demand for the "good" money causing either more or less
of it to circulate. If, for example, an increased issuance of
Macaulay's classic History of England (1877, ch. "bad" money produced a differential yield in favor of the
XXI) is often cited for a famous historical illustration of "bad" money, a comparable amount of the "good" money
the importance of legal-tender laws associated with the could be driven from circulation despite the absence of a
recoinage of 1696. Before 1696, the government of Wil- fixed exchange rate.
liam III accepted coins by their face value or "by tale" To make the example concrete, suppose more Green-
rather than by weight for the discharge of taxes. Milled backs had been issued after the Civil War but the public
coins, which could not be clipped, were melted down and remained convinced that they would, at some future date,
exported while coins that had been shaped by hammer be redeemable in gold at the pre-war parity. Then a lower
were clipped and used to pay taxes. Finally, in 1696, the price of Greenbacks (following the new issuance) would
Parliament declared that light coins could no longer be mean a higher differential yield in favor of Greenbacks.
used to pay taxes. When clipped money was no longer [A formal statement of this theoretical argument is
accepted at its face value for taxes, it began to circulate developed by Salant and Henderson (1978).] If they were
by weight rather than tale. The mechanism that insured a reasonably good substitute for gold money, the
that the inferior money would circulate by tale in typical increased demand for Greenbacks would come at the
private transactions before 1 696 was not the obligation of expense of the demand for gold money, lowering the
sellers but the willingness of sellers as long as they were amount in circulation.
confident that the government would accept the inferior The point of the preceding argument is that a fixed rate
money at its nominal value. As the date of the recoinage of exchange between two non-deposit monies assures that
approached, an increasing number of merchants charged the two monies have equal real yields. With a floating
exchange rate or with deposit monies, differential yields
differential prices depending on whether the buyer paid in
can exist and they will affect money demands. A differen-
clipped or full-bodied money. This historical illustration,
when told in full, supports our view of the role of tial real yield offers a different and alternative mecha-
legal-tender laws in the operation of GL. nism by which one currency can drive another from
l9It is widely believed [cf. Friedman and Schwartz circulation. The "driving mechanism" in GL is the com-
(1963), Hayek (1976)] that a fixed rate of exchange parison of the domestic purchasing power of a commodity
between the "good" and "bad" monies is necessary for the money with its cost of production or value as a commod-
operation of GL. Although a fixed exchange rate has ity. The "driving mechanism" in modern literature on
been, as will be argued in this footnote, necessary for GL competitive monies [Girton and Roper ( 1 98 1 )] is a differ-
to operate in the usual historical setting of commodity or ential real yield. These two analytical structures could, of
paper monies, a fixed exchange rate can be seen from a course, be combined in a general model. But they are
general theoretical perspective as a proxy for identical separated historically - (old) commodity monies did not
real yields. With commodity or paper money, in contrast pay explicit interest whereas (new) deposit monies can
to deposit money, it is difficult to pay explicit interest. and frequently do pay interest. With the switch to deposit
The absence of interest payments in conjunction with a monies and the abandonment of convertibility into a
fixed exchange rate implies that both monies bear the commodity, "good" and "bad" monies can not be defined
same real yields (viz., the single rate of deflation). If the with respect to their bullion values. Since deposit monies
differential real yield is zero, then the public would be can pay explicit interest, it is natural to define "good" and
indifferent about the composition of monies they hold if "bad" monies with respect to their yields. But upon doing
the monies are sufficiently good substitutes. For a given so, we get the modern result that the "good" (higher
overall DM and a reasonable degree of indifference about yielding) money drive the "bad" (lower yielding) money
the composition, the introduction of "bad" money would from circulation whether the rate of exchange is fixed or
displace an equal amount of "good" money. But with a floating. Just as this modern result relies on the absence of
floating exchange rate, the introduction of additional commodity money, GL relies on its presence.
"bad" money could alter the differential real yield in 20See also Wilbur Aldrich (1903, p. 43), Kinley (1904,
either direction and thereby increase or decrease the p. 53), and Taussig (1911, p. 270).

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228 EASTERN ECONOMIC JOURNAL

It is not to be understood that the mass of the Hoarding in the Flow Explanation:
people engage in this occupation of sifting the coin Further Considerations
to get out the heavier pieces. It is the dealer, and
The
concept of hoarding has a long and
especially the dealer in money, who, with his scales
always at hand and always adjusted, quickly
interesting history about which much could be
detects the least difference in weight . . . (Walker,
written. Our own doctrinal research of this
1878, p. 195)
concept is limited and we venture our general-
The mass of people do not follow the market values izations with some hesitation. But there are, it
of gold or silver bullion, nor calculate arithmeti- seems to us, logically distinct differences is the
cally when a profit can be made by buying up this uses of this term which shed light on the
or that coin. The general public knows little about
theory of GL. We will consider three distinct
such things, and if they did, a little arithmetic
would deter them. These matters are relegated by meanings of the hoarding concept.
common consent to the money-brokers, a class of When "hoarding" is used in modern, post-
men who, above all others, know the value of a WWII literature, it usually means or is syn-
small fraction and the gain to be derived from it. onymous with the stock-DM.21 According to
(Laughlin, 1886, p. 26) this modern use of the term, circulating
The great majority of people have no means practi-
money and non-circulating money are both
hoarded. We mention this modern use of the
cally of testing the coins which they receive . . .
(Joseph Nicholson, 1893, p. 44) term as a contrast to earlier uses.
In the GL-literature of the period with
The people, as a general rule, do not reject the which we are concerned, there are two mean-
better, but pass from hand to hand indifferently the
ings of the word "hoarding" which are inter-
heavy and the light coins, because their only use of
the coin is as a medium of exchange. It is those who esting for our study. We have already encoun-
are going to melt, export, hoard, or dissolve the tered one use of the term, as money with
coins of the realm . . . who carefully select for their (strictly speaking) zero velocity. A third use of
purposes the new heavy coins. (Jevons, 1875, p. the term, one which has a very modern ring,
82)
can be found in the writings of Simon New-
If one contrasts these quotations with those
comb (1885), Alfred Marshall (1887), Robert
given a few pages earlier, it becomes clear that
Giffen (1891), and Knut Wicksell (1898).
the flow explanation of GL frequently leads to
"Hoarding" as sometimes used by these
a contradiction. One cannot consistently
authors refers to a speculative demand for
argue both that the typical purchaser con-
capital gain. Like the modern stock-DM, this
sciously spends the worst coins and that he or
use of "hoarding" is a stock concept. It can
she cannot distinguish between the coins. The
flow theorists were concerned with the volume
explain, in at least one important situation,
why a particular money is taken from circula-
of money circulating versus the volume of tion. This situation arises when there is an
money hoarded in their monetary theory of
anticipated change in the mint ratio (when
price level and output determination. But, in
two monies are coined) or parity (when money
their flow explanation of GL, they implicitly
is backed by bullion). The anticipation that
proceeded from volumes to kinds of monies.
convertibility will be abandoned induces spec-
Even if the categories of hoarding and circu-
ulation that can be self-fulfilling. It is not
lating apply to good money and bad money,
necessary for bad money to be introduced, just
respectively, they explain only their differen-
the expectation that a sufficient quantity will
tial velocity. In order for one money to be
exported or melted, its quantity must push
21This use of "hoarding" is found, for example, in
against the stock-DM which serves as a con- Keynes (1936) and in several essays in Frenkel and
straint. Johnson (1976).

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 GRESHAM'S LAW AND THE MODERN THEORY OF THE DEMAND FOR MONEY 229

be introduced can induce hoarding and domestic money. The mechanism that is based
deplete the reserves of the monetary authori- on the comparison of the value of a money as
ty. bullion to its value as money is due to the
This use of hoarding raises several ques- presence of intrinsic value in the commodity
tions. First, is this the type of situation to money - that it can be "consumed." When
which GL refers? Second, is this use of one considers financial assets with no intrinsic
"hoarding" logically equivalent to the stock-value, their relative demands depend only on
DM? We will begin with the latter question. anticipated yields. One could argue that
The speculative demand for a currency changes in relative demands (hoarding one
expected to suddenly appreciate is not equiva- money relative to another fiduciary money)
lent to (what we have called) the stock-DMexplains GL if the "good" money were
when the currency in question is a commodity defined as the money with the greater antic-
or, more generally, a nondeposit money. This ipated capital gain, not as the money whose
distinction is clearest when one reflects on the mint value is lower than its bullion value.
way that interest can be paid on a deposit While this notion of "hoarding" may explain
money. With money on deposit at, say, a bank, which money is taken from circulation
explicit pecuniary interest can be paid contin- through speculation, it does not explain the
uously (or occasionally on the average balance exportation and melting of undervalued cur-
held over time). While interest is accruing, the rency. In fact, the mechanism that takes
deposit is used as a medium of exchange - money out of circulation due to an anticipated
both receipts and expenditures go through the capital gain can, in principle, remove the
account. But with a commodity or paper mon- "bad" currency from circulation and thereby
ey, an interest payment or capital gain thatwork in the direction opposite that of GL.22
accrues at a point in time interferes with the The mechanism is so different from the mech-
medium-of-exchange property of the "mon-anism based on the intrinsic values of curren-
ey." A currency hoarded before an antic- cies that we take this notion of hoarding as not
ipated change in parity ceases to be money. If being an explanation of what is usually
there are two monies, say, gold and silver, thatregarded as GL.23
are good substitutes and there is an expecta-
22One money might be melted or exported if its value as
tion of a change in the mint ratio in favor of bullion tends to exceed its value as money (the usual
gold, speculation or gold hoarding will elimi- mechanism of GL) while, simultaneously, an anticipated
future capital gain due to a change in parity could induce
nate some gold money from circulation and
the public to hoard the other money. In this case, the
the (presumably unchanged) stock demand "bad" money would be hoarded. In practice this problem
for money will have to be fulfilled with more occurred rarely if at all. If, for example, the gold parity
were less than the market clearing price for gold bullion
silver money. Since non-deposit currency such that the authorities had to sell gold to support the
hoarded ceases to be a medium of exchange, official parity, expectations frequently developed that
this notion of hoarding is outside of or not partthey would have to revalue gold; hence, the anticipated
of the stock-DM. change in the mint ratio or parity would induce more gold
to be taken from circulation through hoarding. But the
Use of the stock-DM as distinguished from fact that both the hoarding and the exportation/ melting
hoarding of a physical asset expected to typically go in the same direction should not obscure the
two theoretically distinct mechanisms by which curren-
appreciate reveals two fundamentally dif- cies a taken from circulation.
ferent "driving out" mechanisms that can In much of the literature, "hoarding is placed on a
cause a money to cease circulating. The stock- par with exportation and melting as an avenue or channel
through which good money was driven from circulation.
DM is necessary to explain how much money
To take a typical quote, ". . .the three vents by which good
is driven out due to a divergence between the money escapes: in hoarding, in making payments abroad,
value of the money as bullion and its value as and in selling it by weight" (Gide, 1913, p. 298) The

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230 EASTERN ECONOMIC JOURNAL

Although we distinguished between

IV. GL and the Monetary Approach to the the
stock-DM and hoarding (in Balance
theof Payments
sense of com-
modity speculation),Thus thefar, wemodern
have argued that the conceptio
flow
of money-demand explanation of GL is inadequate and that thedivided
is sometimes
between idle and active balances. The earlier
modern stock concept of the DM is essential
notion of hoarding (in the sense of nonspend-
for explaining how much good money is
ing) is a precursor to the contemporary cate-
melted and/or exported. As we argued in
gory of idle balances. So the question arises:
Section II, the volume of good money driven
How can we simultaneously maintain that the
from circulation is equal to the volume of base
hoarding/circulating distinction used in or
theovervalued money introduced minus any
flow explanation is inadequate to explain growth
GL in the stock-DM. Readers familiar
and that its successor, the idle/active distinc-
with the modern monetary approach to the
tion, are two parts of the modern stock-DM?
balance of payments, MABP, will immedi-
The answer is that the idle/active distinction
ately recognize the similarity between our use
concerns different economic behaviors, not
of the DM for explaining GL and its role in
different kinds of monies. The modern con-
the MABP. Our emphasis of the stock nature
cept of idle or low-velocity balances is not of the DM used in GL is similar to the
intended to apply to a particular subset of the
emphasis that Harry Johnson (1972) has
medium of exchange. It applies to the behav-
given to the stock nature of the monetary
ior of some households or firms that hold high
equilibrium condition imbedded in the
balances relative to their level of income or
MABP.25
expenditures. Persons in some activities turn
their cash balances over faster than persons in
tions do not help explain GL. Suppose, for example, that
other activities. The idle/active categories,
wealthier persons hold more idle balances, the ratio of
just like the hoarding/circulating categories,their money to expenditures is higher than for low income
are not useful for explaining how much money
persons. If this supposition is combined with the 19th
century view that gold was the "rich man's money" and
is removed from the domestic monetary sys-
silver was the commoner's money, then it would seem to
tem.24
support the idea that the good money, gold, was driven
from circulation, in the sense that it was held as idle
balances by the upper class. But then how does one
question is whether such authors [e.g., Paul Einzig (1949, explain the oft-cited French experience of the 1850s in
p. 413), Irving Fisher (1912, p. 222), Roy Garis (1933, p. which the commoner's money, silver, was nearly driven
9), Cyril James ( 1 930, p. 30)] are using "hoarding" in the from circulation? In other words, the money that is driven
sense of speculative demand for capital gain or in the from circulation is determined by comparing the mint
money-not-spent sense of Mill, "money kept in reserve by ratio to the market ratio (for which the first approxima-
individuals to meet contingencies which do not occur." As tion might be relative production costs), not by whether it
we argued in the preceding footnote, hoarding in the sense is used most extensively by parties with low rather than
of speculative demand for capital gain can, theoretically, high velocities.
take the bad rather than the good currency from circula- 25In current literature there are two different views of
tion. And, since it does not rely on the same mechanism or ways to characterize the MABP. One view [cf. Keleher
which removes good coin through exportation and melt- ( 1 978)] concerns the law of one price or market arbitrage,
ing, it would appear incongruous to add hoarding (in the viz., the view that prices between two countries or regions
speculative sense) to these other two "vents by which good can not get out of line. Another view is that the BOP can
money escapes." We conjecture that the "hoarding" is be usefully explained using the categories of the demand
placed on a par with the other two routes for good money and supply of money. Although these two ideas are
to leave to form some connection between the hoarding/ frequently combined, they are logically separable [cf.
circulating distinction of monetary theory and the histori- Girton and Roper (1977)] and we are using the second
cal observation that good money was exported or melted. view as our characterization of the MABP.
But whether it is used in the speculative sense or in the An extensive bibliography of this literature is found in
money-not-spent sense, it does not explain why and how Putnam and Wilford (1978). Applications of the mone-
much good money is exported or melted. tary approach to historical periods involving commodity
One can make some connection between different monies are by McCloskey and Zecher (1976) and Flynn
velocities and different kinds of monies, but these connec- (1978).

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 GRESHAM'S LAW AND THE MODERN THEORY OF THE DEMAND FOR MONEY 231

A basic issue for determining themedium relation

to fall (or keep it from rising faster).
between GL and the MABP is whether the This suggests a similarity the exploration of
exportation and melting of good money in whichGL requires that we pierce the veil of
and the BOP in the MABP are analytically institutional change.
similar.26 With the commodity monies fre- The transition from the GL-world of metal-
quently discussed in GL, there was no re-coins to the MABP-world of fiat monies
lic
corded BOP. If a metallic coin were melted begins with the transition from the gold-coin
to the gold-bullion standard (Ricardo's sug-
into bullion, no accurate records could be kept
of this dimunition of the circulating media. gested plan). The circulation of gold coin was
replaced by the circulation of representative
The melting of full-bodied coin did not involve
fiduciary monies which were convertible into
a central bank or a change in official holdings
of international reserves. Institutional ar- gold bullion. Rather than gold coin being
rangements are so fundamentally different melted, central banks operating under the
gold-bullion standard lost reserves (i.e.,
that there would appear little relation between
the melting of metallic coin discussed in incurred
GL a BOP deficit) when the representa-
and the BOP discussed in the MABP. On the tive money was converted into gold bullion.
other hand, the melting of coin and a modern The gold bullion sold by the central banks
BOP deficit both cause the circulating went both to the bullion market and into the
monetary systems of other countries or the
26There are two fundamentally different concepts of coffers of their central banks. Consequently,
the BOP [cf. Girton and Roper (1981)] and the melting-the BOP deficit under the gold-bullion stan-
and-exportation of good money under GL corresponds to
one concept and not the other. One concept is exchangedard is analytically equivalent to the melting
market pressure, the volume of central bank interventionand exportation of coins under the gold-coin
necessary to keep an exchange rate or a parity value fixedstandard.
[cf. Girton and Roper (1977)]. Another concept is the
interregional BOP, the net flow of money between two The second institutional change that may
obscure the relation between the melting of
regions [cf. Mundell (1961)]. If there is one currency per
region, the two concepts are indistinguishable. When two metallic coin and the modern BOP-concept, is
currencies circulate within one region (or when, in mod-
the change from a gold-bullion standard to the
ern jargon, there is currency substitution), the volume of
intervention necessary to keep their rate of exchange fixedgold-exchange standard. Widespread adop-
is quite distinct from the concept of interregional BOP.
tion of the latter occurred after WWI in an
Since GL is a historical observation concerning multiple
currencies, the relevant BOP concept is the multi-effort to economize on gold. Instead of losing
currency concept of exchange market pressure. The dis-gold as the result of a BOP deficit, monetary
tinction between the BOP concepts provides a solution toauthorities lost foreign exchange (or interest-
the perplexing question of the usefulness of the MABP
over the traditional approach for explaining "the" BOP.bearing assets denominated in foreign cur-
When applied to the interregional BOP, the usefulness ofrency units) under the gold-exchange stan-
the MABP declines with the multiplicity of currencies ofdard. Since the loss of foreign exchange is the
low substitutability. (Their substitutability must be low
since a high degree of substitution between multiplegold-exchange standard counterpart to the
loss of gold under the gold-bullion standard,
currencies approximates a single currency and the dis-
tinction between exchange market pressure and the inter-and since the latter is the counterpart to the
regional BOP is obliterated.) It may be more useful to add
the current account and capital accounts for residents in amelting and/or exportation of gold under the
gold-coin standard, contemporary deficits of
region to determine their BOP against another region
than to add their demands for various monies to explainforeign exchange are the modern counterpart
the interregional BOP through the monetary approach. In
to the removal of good money in GL-discus-
short the MABP has a comparative advantage over the
traditional approach for explaining exchange market sions.
pressure. Similarities between (the theory of) GL and Once the similarity between good money
MABP are between GL and the monetary approach to
exchange market pressure, not the monetary approach exported
to and/or melted and a modern BOP
the interregional BOP. deficit is recognized, then it becomes obvious

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232 EASTERN ECONOMIC JOURNAL

that the MABP and an between good and bad monies

adequate has been super-
theory of GL
ceded by the distinction
may have a lot in common.27 The between
major moneycom
created
monality or similarity against
is, of the course,
purchase of foreign
the assetsrole
(the internationalanalytical
the stock-DM, the central reserves of the monetary
fram
authority)
work of both the MABP andand money
thecreated
theoryagainst theof GL
purchase
Beyond the role of the DM,of domestic
other assets.similaritie
These two
can be recognized. sources of money play the same role in the
In a modern country MABP as the two
with kinds of one
only circulating media
national,
play in GL.
fiduciary money, there appears to be no cou
terpart to the good and Another
bad similarity
monies concerns awith
conclusionwhic
GL was concerned. But the MABP is con- associated with both the MABP and GL but
implied by neither. In the MABP literature
cerned with two sources of money as reflected
in the assets of the central bank. The two the conclusion is frequently drawn that a
sources of money are the net purchasesdomestic of credit expansion by the central bank
is completely offset by a BOP deficit of the
foreign assets (i.e., the international reserves
of the monetary authority) and the net pur- same magnitude. This is the same sort of
conclusion that was given in the quotations
chases of domestic assets (i.e., interest bearing
assets demoninated in local currency) by from the Adam Smith and Simon Newcomb in
central bank. Rather than the public holding Section II [cf. also Barbour (1885), Nicholson
two kinds of monies as they did in the last ( 1 903), Walker ( 1 878)] . Just as we cited some
century, contemporary monetary authorities earlier writers on GL who recognized that the
hold two kinds of assets.28 The distinction offset might not always be 100%, it is well
known [cf. Kouri and Porter (1974)] that the
"Other writers have discussed predecessors of the BOP will not equal the creation of domestic
MABP: Bordo (1980), Fausten (1979), Frenkel (1976), credit if the stock demand for money
and Keleher (1978). Our work suggests that another changes.29
place to look is in the literature on GL.
The relation between the theory of GL and the MABP
becomes even more apparent if one tries to explain the
volume of good money displaced by the introduction of maintained convertibility of one into the other. The point
bad money using the traditional approach to the BOP. to note here is that the government obligation in the case
This is an example of the point of the preceding footnote of distinguishable monies served the same role in the
that the MABP has a comparative advantage explaining operation of G L as the indistinguishability of monies
exchange market pressure as opposed to the interregional created against foreign and domestic assets serves in the
BOP. Note that the model in Section II, which explained MABP.
the pressure (measured by òG) on the domestic currency 29Some of the reasoning underlying the notion that the
value of gold, used the monetary approach (i.e., used the quantity of good money displaced might be less than
demand and supply for money) rather than the traditional quantity of inferior money introduced has a sophisticated
approach (i.e., avoided any reference to the current or ring much like some arguments in MABP literature.
capital accounts). This is the same in which the MABP is Jevons (1875, p. 139) and Walras (1954, p. 360)
essential to explain GL. With multiple monies circulating discussed a "compensatory action" and Walker (1897, p.
within one region, it would be less useful to try to explain 149) discussed a "compensating effect." According to
the amount of money demonetized (the BOP deficit) this idea [which is also mentioned, but not with the same
using the traditional approach to the BOP. name, by Bordo (1975) in his discussion of Cairnes], the
The money (e.g., deposits at the central banks) absorption of overvalued money from the bullion market
created against the purchase of domestic assets is, of and the new supply of demonetized metal to the bullion
course, indistinguishable from the money created against market affects the market ratio of the two metals. In
the purchase of foreign assets. This indistinguishability terms of the model in Section II, this implies a movement
assures that units of this identical money will circulate at in R and, therefore, P. This means that the very displace-
par with one another. In previous centuries, the monies ment of good with bad money allows the domestic price
were frequently distinguishable. In order that they cir- level to rise and the domestic demand for money to
culated by tale or at parity with one another, the govern- consequently increase such that the volume of good
ment had to accept either money for taxes and duties (as money demonetized will be less than the quantity of bad
discussed in Section II), or the government could have money introduced. This is exactly the reasoning which lies

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 GRESHAlvTS LAW AND THE MODERN THEORY OF THE DEMAND FOR MONEY 233

An apparent dissimilarity is thatBarbour,

GL was Sir David. The Theory of Bimetallism.
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words, GL concerned the exportationBordo,
and/orMichael D. "John E. Cairnes on the Effects
of the Australian Gold Discoveries, 1851-73:
melting of money rather than its importation
An Early Application of the Methodology of
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Positive Economics." History of Political
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Economy 7(1975): 337-59.
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of Richard Cantillon." Paper
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nia, 1980.
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Barro, Robert. "Money and th
the Gold
of inferior money can just as easily explain the Standard." Economic Journal
89(March
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Baumöl, William. "The Transactions Demand f
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Cash: An Inventory Theoretic Approach."
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Quarterly Journal of Economics 66 (Novem
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ber 1952): 545-56.
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