Gresham's law applies specifically when there are two forms of commodity money in circulation which are forced, by the application of legal-tender laws, to be respected as having face values in a fixed-ratio for marketplace transactions.
An example is the US dollar, which the US government pledged to redeem for 1/20.67 ounce (1.5048 g) of gold until 1934. The value of dollar coins and, later, dollar notes was very close to the commodity gold value at that fixed rate. In 1934, Franklin Roosevelt declared via Executive Order 6102 that the dollar would henceforth be redeemable at a rate of 1/35 ounce (0.887 g) of gold. This arbitrary, abrupt change in the government redemption value, along with severe restrictions on the private sale of gold, created a permanent dislocation between the face value of dollar notes and the market value of gold bullion. By 1971, the difference between the nominal rate (1/35 ounces) and the market rate of exchange between the dollar and gold had grown so wide due to the printing of so many dollars that the US gave up the 1/35 ounce exchange rate (the Nixon Shock), and was forced to let the dollar float freely against gold.
In the absence of legal-tender laws, metal-coin money will freely exchange at somewhat above bullion market value. This is not a purely theoretical result, but rather may be observed today in bullion coins such as the Krugerrand (South Africa) and the American Gold Eagle (United States). Coined money is of a known purity, and in a convenient form to handle. People prefer trading in coins than in anonymous hunks of bullion, so they attribute more value to the coins. There is also a certain demand from coin collectors. Thus, coining is frequently profitable.
In Gresham's day, bad money included any coin that had been "debased." Debasement was often done by members of the public, cutting or scraping off some of the metal. Coinage could also be debased by the issuing body, whereby less than the officially mandated amount of precious metal is contained in an issue of coinage, usually by alloying it with base metal. Other examples of "bad" money include counterfeit coins made from base metal. In all of these examples, the market value was the supposed value of the coin in the market.
In the case of clipped, scraped or counterfeit coins, the market value has been reduced by fraud, while the exchange value remains at the higher value. On the other hand, with coinage debased by a government issuer the market value of the coinage was often reduced quite openly, but the exchange value of the debased coins was held at the higher level by legal tender laws.
All modern money is "bad money" in this sense, since fiat money has entirely replaced the commodity money to which Gresham's law applies. The ubiquity of fiat money could indeed be taken as evidence for the truth of Gresham's law.
Consider a customer purchasing an item which costs five pence, who has in their possession several silver sixpence coins. Some of these coins are more debased, while others are less so — but legally, they are all mandated to be of equal value. The customer would prefer to retain the better coins, and so offers the shopkeeper the most debased one. In turn, the shopkeeper must give one penny in change — and has every reason to give the most debased penny. Thus, the coins that circulate in the transaction will tend to be of the most debased sort available to the parties.
If "good" coins have a face value below that of their metallic content, individuals may be motivated to melt them down and sell the metal for its higher bullion value, even if such defacement is illegal. For an example of this, consider the 1965 US Half-dollars which were made from only 40% silver. The previous year the half-dollar was 90% silver. With the release of the 1965 half, which was legally required to be accepted at the same value as the previous year's 90% halves, the older 90% silver coinage of the US quickly disappeared from circulation, and the debased money was allowed to circulate in its stead. As the price of bullion silver rose above the face value of the coins, many of those old half-dollars were melted down. With the 1971 issue the government gave up on including any silver in the half dollars. A similar situation is currently (2007) occurring with the rising price of copper and zinc, and has led the U.S. government to ban the melting or mass exportation of one and five cent coins, respectively.
In addition to being melted down for its bullion value, money that is considered to be "good" tends to leave an economy through international trade. International traders are not bound by legal tender laws the way citizens of the country are, so they will offer higher value for good coins than bad ones, and thus higher value than can be obtained within the country. The good coins may leave their country of origin to become part of international trade. Thus, the good money is driven out of the country of issue, escaping that country's legal tender laws and leaving the "bad" money behind. This occurred in Britain during the period of the Gold Exchange Standard.
Gresham made his observations of good and bad money while in the service of Queen Elizabeth, with respect only to the observed poor quality of the British coinage. The previous monarchs, Henry VIII and Edward VI, had forced the people to accept debased coinage by means of their legal tender laws. Gresham also made his comparison of good and bad money where the precious metal in the money was the same. He did not compare silver to gold, or gold to paper.
An early form of Gresham's Law was described by Nicolaus Copernicus in the treatise Monetae cudendae ratio, first drawn up in the year (1519) that Thomas Gresham was born. Copernicus wrote that "bad (debased) coinage drives good (un-debased) coinage out of circulation.
The passage from The Frogs referred to is as follows; it is usually dated at 405 B.C.:
The experiences of dollarization in countries with weak economies and currencies (for example Israel in the 1980s, Eastern Europe and countries in the period immediately after the collapse of the Soviet bloc, or South American countries throughout the late twentieth and early twenty-first century) may be seen as Gresham's Law operating in its reverse form (Guidotti & Rodriguez, 1992), since in general the dollar has not been legal tender in such situations, and in some cases its use has been illegal.
These examples show that in the absence of legal tender laws, Gresham's law works in reverse. If given the choice of what money to accept, people will transact with money they believe to be of highest long-term value. However, if not given the choice, and required to accept all money, good and bad, they will tend to keep the money of greater perceived value in their possession, and pass on the bad money to someone else. Said in another way, in the absence of legal tender laws, the seller will not accept anything but money of real worth (good money), while the existence of legal tender laws will force the seller to accept money with no commodity value (bad money). Thus, the buyer will always try to spend his bad money first, but in the absence of legal tender laws, the seller will not accept money with no real worth.
In the market for second hand cars, lemon automobiles (analogous to bad currency) will drive out the good cars. The problem is one of asymmetry of information. Sellers have a strong financial incentive to pass all cars off as "good" cars, especially lemons. This makes it chancy to buy a good car at a fair price, as the buyer risks overpaying for a lemon. The result is that buyers will only pay the fair price of a lemon, so at least they won't be ripped off. High quality cars tend to be pushed out of the market, because there is no good way to establish that they really are worth more. The Market for Lemons is a work that examines this problem in more detail.
Schools that respond to these incentives (and focus all their attention on those at the cusp of passing) in locations which allow easy switching of schools will tend to drive away the ignored students for whom the value of their education is not adequately captured by the Pass/Fail grade, as Gresham's Law predicts.
A case in education where Gresham's Law generally does not apply is with "diploma mills," schools that offer diplomas even to those with very low qualifications for a price. It may seem that according to Gresham's law these "bad" diplomas ought to drive out the "good" diplomas. However, unlike money, most countries have no law requiring employers to accept all diplomas as being of equal value. Each employer is free to assess the value of qualifications as they see fit. In those nations or governmental organizations where the law does require blindness, this effect does occur .
Within the drug/alcohol recovery field, Gresham's Law has been invoked to explain the diminishing success rate of Alcoholics Anonymous. In an address before the AA General Service Conference in 1976 , Tom P. pointed to the two competing methods of recovery in AA. One strain is based upon meeting attendance while the second method is based upon taking the 12 Steps to effect a spiritual experience. Where the competing methods are presented as equals, recovery based upon meeting attendance will drive out recovery based upon spiritual experience. Tom P. noted recovery dependent upon AA meetings creates a condition where one is 'dry' but not successful in life. These people will tend to dominate a group and drive out those who have had have affected spiritual experiences and thus have other options in life.
Gresham's Law was famously used by the current Portuguese president Cavaco Silva to depict the mediocrity in political recruitment, clearly hinting that the at the time prime-minister Santana Lopes (a conservative populist who replaced Durão Barroso, nominated president of the EU Commission) was "bad money", driving away the high-profile credible politicians (the "good money"). After months of protests and instability, Santana Lopes was exonerated by president Jorge Sampaio, who called for a parliamentary election. Santana's party, the PSD eventually lost to José Sócrates's socialist party. Cavaco Silva was elected President a year later.
Gresham's law has also been applied to the field of real estate and other investments. In such circumstances, the "good" money is money that is brought by patient investors, often not encumbered by debt. "Bad money" is usually borrowed or otherwise leveraged, and thus in need of quick and reliable returns. The investment of bad money can create gyrations in the market, as the holders flip the investments to squeeze out a return and payoff, or manage, the debt. The gyrations, as well as the possibility of market bubbles, can cause the good money to exit the market.