Gresham's Law

A coin is valued for the metal it contains, but may for a time be accepted for the amount of metal it represents. That is, a coin that represents an ounce of silver will become worn by use, or its edges may be shaved intentionally, or it may be debased even from the moment it is minted, until it contains a few grains less than an ounce. Yet it will still be traded as if it contains the full ounce so long as it is accepted as that value by those who trade products for coin. It is inevitable, however, that the coin will be assessed and revalued for its actual content, and the individual holding the coin will suffer the loss.

Gresham's law, which is an observation of behavioral tendencies maintains that worse coins will tend to drive the better ones from circulation. That is, when the market recognizes that some coins that represent an ounce of silver contain nine-tenths of an ounce, then all such coins will be valued as being nine-tenth, and those that actually contain the full ounce will be taken out of circulation. Or in smaller words, "bad money drives out the good."

One reason for this is the tendency of buyers to give as little value as possible in exchange: if the merchant will accept nine-tenths of an ounce, it is not rational to give a full ounce, so the customer will pay with the coin that has the least value. Another reason is that coins weighting a full ounce can be shaved down to nine-tenths, or melted down and sold for their weight in debased coins - so money-changers can increase their profits by taking heavy coins out of circulation.

The same principle occurs when there are coins of various metals in circulation: silver, copper, nickel, and brass. These metals have industrial uses, and the values of these metals fluctuate with supply and demand in the market. So if coinage is minted at a time when five copper coins are worth as much as a single nickel coin, and then there follows a shortage of nickel such that it takes seven copper coins to purchase the weight of the nickel, then the nickels will be removed from circulation as buyers prefer to pay five coppers instead of the one nickel (which is denominated as being worth five, but is actually worth seven if melted down and sold as metal).

The nominal value of a currency cannot be maintained or defended. In instances when a nation attempted to defend the exchange ratio of its own currency, people simply stopped bringing the undervalued coins to the market and the coins themselves were often traded on the international market where they were valued for their actual weight.

This also applies in cases where there is doubt about the redemption of paper currency. Because the amount of paper currency exceeds the specie to back it, it is traded on faith in the marketplace. If traders begin to suspect that they may not be able to redeem it (for lack of specie), they are inclined to get rid of it as soon as possible to leave someone else holding an unredeemable note. In such circumstances, buyers wish to spend their paper money and will horde their coins. Again, the bad money drives out the good.