Gresham’s Law      from Wikipedia, the free encyclopedia

”’Gresham’s law”’ is commonly stated as: "When there is a legal tender currency, bad money drives good money out of circulation".  

Gresham’s law applies specifically when there are two forms of commodity money in circulation which are forced, by the application of legal tender laws, to be respected as having the same face value in the marketplace.  It is named after Sir Thomas Gresham, an English financier in Tudor times.  

The terms "good" and "bad" money are used in a technical sense, and with regard to exchange values imposed by legal tender legislation, as follows:  

Good money is money that has little difference between its exchange value and its commodity value.  In the original discussions of Gresham’s law, money was conceived of entirely as metallic coins, so the commodity value is the market value of the coined bullion of which the coins are made.  

An example is the US dollar, which, prior to the 1900s was equal to 1/20.67 ounce (1.5048 g) of gold, and carried an exchange value roughly equal to its coined gold market value.  

In the absence of legal tender laws, metal coin money will freely exchange at somewhat above bullion market value. (This is not a purely theoretical result, but rather can be observed today in bullion coins such as the Krugerrand (South Africa) and the American Gold Eagle (United States)). Coined money is of a known purity, and in a convenient form to handle. People prefer trading in coins to anonymous hunks of bullion, so they attribute more value to the coins. There is also a certain demand by coin collectors.  Thus, coining is frequently profitable.  

Bad money is money that has a substantial difference between its commodity value and its market value, where market value is lower than exchange value.  

In Gresham’s day, bad money included any coin that had been "debased." Debasement was often done by members of the public, cutting or scraping off some of the metal. Coinage could also be debased by the issuing body, whereby less than the officially mandated amount of precious metal is contained in an issue of coinage, usually by alloying it with base metal. Other examples of "bad" money include counterfeit coins made from base metal. In all of these examples, the market value was the supposed value of the coin in the market.  

In the case of clipped, scraped or counterfeit coins, the market value has been reduced by fraud, while the exchange value remains at the higher value.  On the other hand, with coinage debased by a government issuer the market value of the coinage was often reduced quite openly, but the exchange value of the debased coins was held at the higher level by legal tender laws. 

All modern money is "bad money" in this sense, since fiat money has entirely replaced the commodity money to which Gresham’s law applies.  The ubiquity of fiat money could indeed be taken as evidence for the truth of Gresham’s law. 

Gresham’s law says that any circulating currency consisting of both "good" and "bad" money (both forms required to be accepted at equal value under legal tender law) quickly becomes dominated by the "bad" money.  This is because people spending money will hand over the "bad" coins rather than the "good" ones, keeping the "good" ones for themselves.  

Consider a customer purchasing an item which costs five pence, who has in their possession several silver sixpence coins. Some of these coins are more debased, while others are less so — but legally, they are all mandated to be of equal value. The customer would prefer to retain the better coins, and so offers the shopkeeper the most debased one. In turn, the shopkeeper must give one penny in change — and has every reason to give the most debased penny. Thus, the coins that circulate in the transaction will tend to be of the most debased sort available to the parties.  

If "good" coins have a face value below that of their metallic content, individuals may be motivated to melt them down and sell the metal for its higher bullion value, even if such defacement is illegal. For an example of this, consider the 1965 US Half-dollars which were made from only 40% silver. The previous year the half-dollar was 90% silver.  With the release of the 1965 half, which was legally required to be accepted at the same value as the previous year’s 90% halves, the older 90% silver coinage of the US quickly disappeared from circulation, and the debased money was allowed to circulate in its stead. As the price of bullion silver rose above the face value of the coins, many of those old half-dollars were melted down.  With the 1971 issue the government gave up on including any silver in the half dollars.  A similar situation is currently (2007) occurring with the rising price of zinc and copper, and has lead to attempts by the U.S. government to ban the melting or mass exportation of one and five cent coins, respectively.  

In addition to being melted down for its bullion value, money that is considered to be "good" tends to leave an economy through international trade. International traders are not bound by legal tender laws the way citizens of the country are, so they will offer higher value for good coins than bad ones, and thus higher value than can be obtained within the country.  The good coins may leave their country of origin to become part of international trade. Thus, the good money is driven out of the country of issue, escaping that country’s legal tender laws and leaving the "bad" money behind.  This occurred in Britain during the period of the Gold Exchange Standard.