What is Gresham's Law
Gresham's law is a monetary principle stating that "bad money drives out good." In currency valuation, Gresham's law was originally based on the observation that if a new coin ("bad money") is assigned the same face value as an older coin containing a higher amount of precious metal ("good money"), then the new coin will be used in circulation while the old coin will be hoarded and disappear from circulation.
BREAKING DOWN Gresham's Law
Gresham's law today generally applies to a situation where two monetary units given the same face value will result in the overvalued one (bad money) being used and the undervalued one (good money) disappearing from circulation.
Coins were first made of gold, silver and other precious metals, which gave them their value. Over time, the number of precious metals used to make the coin decreased because the metals were worth more on their own than when minted into the coin itself. However, despite this, new coins were given the same face value as the existing coins for people to conduct their transactions. Because the value of the metal in the old coins was higher than the coin's face value, people would melt the coins down and sell the metal, or they would simply hoard them as a store of value. The new coins, with less precious metal content, would be considered "overvalued" and thus spent in transactions, while the old coins would become "undervalued" - hence, the hoarding effect, driving out the "good money" from circulation.
Name Origin of Gresham's Law
Gresham's law was named after Sir Thomas Gresham (1519-1579), an English financier who served the Crown and founded the Royal Exchange of the City of London. The idea that "bad money drives out good" was observed by Gresham, as it had been elsewhere in the past. The theory was not given the formal name, Gresham's law, until the middle of the 19th century, when Scottish economist Henry Dunning Macleod attributed the monetary phenomenon to Gresham.