Gresham's Law

Gresham's Law states that an overvalued money will drive undervalued money out of the market. Or more simply, "bad money drives out good".

How It Works
Gresham's Law comes into play, when several types of money have a conversion ratio specified by legal tender laws, different from their market price.

For example, let's say the law sets the ratio at 20 ounces of silver for one ounce of gold; but the market price of gold is only 15 ounces of silver. Any contract or debt in silver can be now paid in gold. So instead of expending 20 silver, the debtor will buy an ounce of gold for 15 ounces of silver. As a result, no one will be willing to enter a contract quoted in silver.

The undervalued money will vanish from the market, bringing down prices quoted in it. Those still using it will likely find themselves in trouble, because they made debts and investments under the old price level and expected their incomes to be correspondingly higher. The 'good money' will be held by the users of money, or sold into other countries, where the local laws do not apply. This exchange of currencies takes time, while the supply of money shrinks. This produces a temporary deflationary effect.

The Law is a special case of the usual effects of price controls by government: in this case, the government’s artificial fixing of an exchange rate between two or more moneys creates a shortage of the artificially under-valued money and a surplus of the over-valued money.

History
The law was named after Sir Thomas Gresham, a sixteenth century financial agent of the English Crown in the city of Antwerp, to explain to Queen Elizabeth I what was happening to the English shilling. Her father, Henry VIII, has replaced 40 percent of the silver in the coin with base metals, to increase the government’s income without raising taxes. Astute English merchants and even ordinary subjects would save the good shillings from pure silver and circulate the bad ones; hence, the bad money would be used whenever possible, and the good coinage would be saved and disappear from circulation.

But it was known long before, for example, in Aristophanes’s poem "The Frogs" and in the Treatise of Nicholas Oresme, which also pointed out the deflationary impact. Copernicus declared in his Monetae cudendae ratio, that it is impossible for good full-weighted coin and base and degraded coin to circulate together, if their value is fixed by the state. Sir Thomas Smith was the first to express the law in England, rather than Gresham.

The Chinese thinker Yeh Shih (A.D. 1150-1223), anticipated Gresham's Law as well: "The men who do not inquire into the fundamental cause," he wrote, "simply think that paper should be used when money is scarce. But as soon as paper is employed, money becomes still less. Therefore, it is not only that the sufficiency of goods cannot be seen, but also that the sufficiency of money cannot be seen."

Links

 * Gresham's Law on Wikipedia
 * Monetae cudendae ratio a paper on coinage by Nicolaus Copernicus
 * What Has Government Done to Our Money? by Murray Rothbard
 * Gresham's Law by George Selgin
 * Gresham's Law Briefly Revisited in a Constitutional Context, March 2010, Michael Rozeff
 * Multiple Currencies and Gresham’s Law in Zimbabwe by Finbar Feehan-Fitzgerald, January 2015