Gresham's Law: Definition, Effects, and Example

What Is Gresham's Law?

Gresham's law is a principle that states that "bad money drives out good" and can be applied to the currency markets.

The law stemmed from the historical use of precious metals to manufacture coins and their subsequent value. Since the abandonment of metallic currency standards, the theory often describes the stability and movement of different currencies in global markets.

Understanding Gresham's Law

Sir Thomas Gresham lived from 1519 to 1579 and wrote about the value and minting of coins while working as a financier and later founded the Royal Exchange of the City of London. When Henry VIII changed the composition of the English shilling, replacing a substantial portion of the silver with base metals, citizens separated the English shilling coins and hoarded the coins containing more silver which were worth more than their face value.

Both currency types were liquid and available simultaneously for use as acceptable forms of exchange. Gresham observed that bad money was driving out good money from circulation. Bad money is a currency with equal or less value than its face value. Good money has the potential for a greater value than its face value. People will choose to use bad money first and hold onto good money. The Scottish economist Henry Dunning Macleod attributed this law to Gresham in the 19th century.

Good Money vs. Bad Money

Historically, mints manufactured coins from gold, silver, and other precious metals, which gave the coins their value. Issuers of coins sometimes lowered the level of the precious metals used and passed the coins as full-value coins. New coins with less metal content had less market value and traded at a discount. The old coins retained a higher value.

However, legal tender laws mandated that new coins with less metal content have the same face value as older coins. The new coins were legally overvalued, and the old coins were legally undervalued. Governments, rulers, and other coin issuers often implemented this policy to obtain revenue and repay debts borrowed in old coins using new coins at par value.

Legally forced to treat both types of coins as the same monetary unit, buyers passed along their less valued coins as quickly as possible and held onto the old coins, thus debasing the currency, creating a fall in the purchasing power of the currency units. To fight Gresham’s law, governments often blamed speculators, implemented currency controls, prohibited removing coins from circulation, or confiscated privately owned precious metal supplies.

Gresham's Law and Legal Tender

Gresham's law is evident in a modern economy with legal tender laws. When all currency units are legally mandated to be recognized at the same face value, the traditional version of Gresham's law operates. In the absence of effectively enforced legal tender laws, Gresham's law operates in reverse as good money drives bad money out of circulation where people can decline to accept less valuable money.

With the adoption of paper money as legal tender, the issuers of money can print money into existence and this ongoing debasement has led to a persistent trend of inflation as the norm in most economies. If a currency loses value rapidly, people tend to stop using it in favor of more stable foreign currencies, sometimes even in the face of repressive legal penalties.

During a period of hyperinflation in Zimbabwe in 2008, the Zimbabwe dollar was the legal currency and many people abandoned its use in transactions, eventually forcing the government to recognize de facto and subsequent de jure dollarization of the economy. In the chaos of an economic crisis with a near-worthless currency, the government was unable to enforce its legal tender laws. Good, stable money drove bad, hyperinflated money out of circulation. 

Example of Gresham's Law

In 1982, the U.S. government changed the composition of the penny to contain 97.5% zinc. This change made pre-1982 pennies worth more than their post-1982 counterparts, while the face value remained the same. Due to the debasement of the currency and resulting inflation, copper prices rose from an average of $0.6662/lb. in 1982 to $3.0597/lb. in 2006 with the purchasing power of a penny falling by nearly 80%.

As people began harvesting copper from old pennies, the U.S. imposed stiff penalties for melting coins, and the legislation carried a $10,000 fine or up to five years in prison if convicted of the offense.

The Bottom Line

Gresham's law states that "bad money drives out good" and is a monetary principle that can be applied to the currency markets. During the historical use of precious metals to manufacture coins, Gresham's law applied to the changing value of coins and their contents. Since the global financial system has transitioned to fiat currencies, examples of Gresham’s law are rare.