Legal tender

Legal tender is a money, that, by law, can be used to make payments against the will of an exchange partner. Legal tender laws were instrumental in promoting fractional reserve banking.

Exchange rate
Legal tender laws would merely complicate trading, but practically always specify a conversion ratio - a price - between the privileged money and other monies, different from the market price. This is done to benefit debtors (like the state).

For example, the law sets the ratio at 20 ounces of silver for one ounce of gold, but the market price is 15. A contract or debt for 20 ounces of silver can be now paid with 1 ounce of gold - which the debtor can buy for much less than was the original debt. As a result, no one will be willing to enter a contract quoted in silver.

This is called Gresham's Law: an overvalued money will drive undervalued money out of the market. Or put simply, "the bad money drives the good money out". People stop using the metal, that is in reality more valuable than according to the letter of the law. The metal will be held or sold into other countries.

Bimetallism
Bimetallism is a currency system with forced exchange ratios between coins from different metals, often between gold and silver. In accord with the Gresham's Law, if a metal is undervalued, it will be driven out of circulation. This was notable, for example, in the British currency reform of 1717, or the US reforms of 1792 and 1834.

In 1792, the U.S. Congress voted a Coinage Act into existence that decreed the exchange rate between gold and silver to be 1 to 15. The market rate was 1 to 15.5, however, and after a few years the artificially undervalued gold had all but disappeared from circulation.

The U.S. Coin Act of 1834 fixed the legal exchange ratio between gold and silver at 1 to 16, and the entire silver currency of the country was replaced with a gold currency. Fractional reserve banking has benefited in both exchanges.

The bimetallic standard of France and in the other countries of the Latin Monetary Union resulted in the emergence of de facto gold monometallism.

Links

 * Legal tender on Wikipedia
 * History of the United States dollar on Wikipedia
 * Down with Legal Tender by Friedrich A. Hayek, excerpted from Denationalisation of Money: the Argument Refined.