The original concept of Gresham’s Law was applied to debased coins of monometallism (Gold Standard of that time) only. However, the law can be extended to bimetallism as well as the system of paper money and metallic money of the modern era.
Under bimetallism (where coins of two metals generally gold and silver are circulated), coins of over-valued metal are called “bad money” and coins of under-valued metal as “good money.”
Under the paper standard, if both standard coins of superior metal and inconvertible paper notes are circulating together, metallic coins are regarded as “good money” and paper notes as “bad money.”
Thus, Gresham’s Law implies that under bimetallism over-valued coins will drive under-valued coins out of circulation. Similarly, paper notes will drive out standard coins from circulation.
This has happened in India during World War II, when all coins suddenly became scarce in the country. On account of insecurity felt by the people caused by the Japanese bombardment, the value of paper money became much less than that of coins having the same intrinsic worth. As a result, coins were extensively hoarded by the people.
Thus, paper money being bad money; it drove the coins (good money) out of circulation. Even today the law operates to some extent as between new notes and old and soiled notes, new and old subsidiary (token) coins.
People generally try to keep fresh notes and shining coins in their pockets and pay out the soiled notes and worn-out coins first. Thus, the law is based on human psychology which causes the bad money to drive good money out of circulation. Marshall, however, presented the generalised version of the law as follows:
There are, however, certain limitations to Gresham’s Law:
1. An essential condition for the operation of the law is that there should be enough bad money in circulation to satisfy people’s demand for media of exchange.
If there is a shortage of currency for its normal requirements, the law will not operate and good and bad coins will circulate side by side.
Thus, the law has a greater tendency to operate when the currency available is in excess of its normal requirements. In other words, it is likely to apply more under conditions of inflation (due to excessive money supply) than under conditions of deflation.
2. When people in general refuse to accept bad money, good money will perforce continue to be used in exchange. Then, the law will not operate.
3. The law assumes that people can distinguish bad money from good and act accordingly. But, if the people are so ignorant, particularly village folks, that they do not know the difference between good money and bad money, the law have little chance of operating.
Development of the banking habit among the people also checks the operation of Gresham’s Law by discouraging hoarding.
For depositing money with banks, it is immaterial whether you pay good money or bad, as both are acceptable so long as they are of full legal tender.