Gresham’s law in its simple form states that when good and bad money are together in circulation as legal tender, bad money tends to drive good money out of circulation. This implies that less valuable money tends to replace more valuable money in circulation.
This law was enunciated by Sir Thomas Gresham who was the financial adviser to Queen Elizabeth I in the 16th century in England.
Gresham was, however, not the first to develop this law, but it became associated with his name after he explained a problem faced by the Queen.
With a view to reform the currency system, the Queen tried to replace bad coins of the previous regime by issuing new full-weighted coins.
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But to her surprise, as soon as new coins were circulated, they disappeared and the old debased coins continued to remain in circulation.
She sought the advice of Sir Thomas Gresham, who provided his explanation in the form of the law which states: “Bad money tends to drive out of circulation good money.”
The theoretical explanation of this law is in terms of the divergence of the market rate of exchange of the two currencies from mint rate.
If the mint rate (i.e., the official rate of exchange between two types of money) differs from the market rate of exchange between the two types of money, then the over-valued money at the mint will tend to drive the under-valued money out of circulation.
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Suppose under bimetallism, one gold coin exchanges for 10 silver coins, i.e., the official rate of exchange or the mint rate is 1:10.
Now, if the market rate is 1:12, then gold is under-valued and silver is over-valued at the mint rate (i.e. the market rate of gold exceeds the mint rate and the market rate of silver is less, than its mint rate).
In this case, gold will become good money and silver a bad money.-The bad money (silver) will drive out good money (gold) from circulation.