Federal Reserve Bank of Minneapolis Research Department Staa Report 215 a Model of Commodity Money, with Applications to Gresham's Law and the Debasement Puzzle Federal Reserve Bank of Chicago I. the Basic Model Ii. Equilibrium and Gresham's Law

We develop a model of commodity money and use it to analyze the following two questions motivated by issues in monetary history: What are the conditions under which Gresham's Law holds? And, what are the mechanics of a debasement (lowering the metallic content of coins)? The model contains light and heavy coins, imperfect information, and prices determined via bilateral bargaining. There are equilibria with neither, both, or only one type of coin in circulation. When both circulate, coins may trade by weight or by tale. We discuss the extent to which Gresham's Law holds in the various cases. Following a debasement, the quantity of reminting depends on the incentives ooered by the sovereign. Equilibria exist with positive seigniorage and a mixture of old and new coins in circulation. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Banks of Minneapolis or Chicago or the Federal Reserve System. This paper develops a model where metal coins are used as media of exchange, and uses the model to analyze two closely related questions in monetary economics: What are the conditions under which Gresham's Law holds? And, what are the mechanics of a debasement, an operation in which the metallic content of coins is lowered? Gresham's Law, as it is commonly stated, asserts that bad money drives out good money. This is usually taken to mean that when two similar commodity monies compete, and one is in some sense inferior to the other, the inferior money will circulate and the superior money will not, but will instead be hoarded or shipped abroad. It is invoked in a variety of contexts, such as, for example, competition between light and heavy coins of a given type, or between coins of diierent metals like gold and silver. Despite it being one of the most generally accepted and frequently cited propositions in economics, we think that existing theoretical analyses of Gresham's Law are lacking, for reasons discussed below. 1 Debasements have been observed for centuries and were actually quite common in medieval and modern European economies. The monetary system of that time consisted of metal coins (gold and silver) produced by mints under the direct control of sovereigns. Individuals could bring metal to the mint to be made into new coins of the same metal. This was costly, because the total metal content of the new coins returned was …