Price specie flow mechanism
Encyclopedia
The price–specie flow mechanism is a logical argument by David Hume
against the Mercantilist (1700–1776) idea that a nation should strive for a positive balance of trade
, or net exports. The argument considers the effects of international transactions in a gold standard
, a system in which gold is the official means of international payments and each nation’s currency is in the form of gold itself or of paper currency fully convertible into gold.
Hume argued that when a country with a gold standard had a positive balance of trade, gold would flow into the country in the amount that the value of exports exceeds the value of imports. Conversely, when such a country had a negative balance of trade, gold would flow out of the country in the amount that the value of imports exceeds the value of exports. Consequently, in the absence of any offsetting actions by the central bank on the quantity of money in circulation (called sterilization
), the money supply would rise in a country with a positive balance of trade and fall in a country with a negative balance of trade. Using a theory called the quantity theory of money
, Hume argued that in countries where the quantity of money increases, inflation would set in and the prices of goods and services would tend to rise while in countries where the money supply decreases, deflation would occur as the prices of goods and services fell.
The higher prices would, in the countries with a positive balance of trade, cause exports to decrease and imports to increase, which will alter the balance of trade downwards towards a neutral balance. Inversely, in countries with a negative balance of trade, the lower prices would cause exports to increase and imports to decrease, which will heighten the balance of trade towards a neutral balance. These adjustments in the balance of trade will continue until the balance of trade equals zero in all countries involved in the exchange.
The price–specie flow mechanism can also be applied to a state's entire balance of payments, which accounts not only for the value of net exports and similar transactions (the current account
), but also the financial account, which accounts for flows of financial assets across countries, and the capital account
, which accounts for non-market and other special international transactions
. But under a gold standard
, transactions in the financial account would be conducted in gold or currency
convertible into gold
, which would also affect the quantity of money in circulation in each country.
David Hume
David Hume was a Scottish philosopher, historian, economist, and essayist, known especially for his philosophical empiricism and skepticism. He was one of the most important figures in the history of Western philosophy and the Scottish Enlightenment...
against the Mercantilist (1700–1776) idea that a nation should strive for a positive balance of trade
Balance of trade
The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation's imports and exports...
, or net exports. The argument considers the effects of international transactions in a gold standard
Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard...
, a system in which gold is the official means of international payments and each nation’s currency is in the form of gold itself or of paper currency fully convertible into gold.
Hume argued that when a country with a gold standard had a positive balance of trade, gold would flow into the country in the amount that the value of exports exceeds the value of imports. Conversely, when such a country had a negative balance of trade, gold would flow out of the country in the amount that the value of imports exceeds the value of exports. Consequently, in the absence of any offsetting actions by the central bank on the quantity of money in circulation (called sterilization
Sterilization (economics)
Sterilization in macroeconomics refers to the actions taken by a country's central bank to counter the effects on the money supply caused by a balance of payments surplus or deficit....
), the money supply would rise in a country with a positive balance of trade and fall in a country with a negative balance of trade. Using a theory called the quantity theory of money
Quantity theory of money
In monetary economics, the quantity theory of money is the theory that money supply has a direct, proportional relationship with the price level....
, Hume argued that in countries where the quantity of money increases, inflation would set in and the prices of goods and services would tend to rise while in countries where the money supply decreases, deflation would occur as the prices of goods and services fell.
The higher prices would, in the countries with a positive balance of trade, cause exports to decrease and imports to increase, which will alter the balance of trade downwards towards a neutral balance. Inversely, in countries with a negative balance of trade, the lower prices would cause exports to increase and imports to decrease, which will heighten the balance of trade towards a neutral balance. These adjustments in the balance of trade will continue until the balance of trade equals zero in all countries involved in the exchange.
The price–specie flow mechanism can also be applied to a state's entire balance of payments, which accounts not only for the value of net exports and similar transactions (the current account
Current account
In economics, the current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade , net factor income and net transfer payments .The current account balance is one of two major...
), but also the financial account, which accounts for flows of financial assets across countries, and the capital account
Capital account
The current and capital accounts make up a country's balance of payment . Together these three accounts tell a story about the state of an economy, its economic outlook and its strategies for achieving its desired goals...
, which accounts for non-market and other special international transactions
Financial transaction
A financial transaction is an event or condition under the contract between a buyer and a seller to exchange an asset for payment. It involves a change in the status of the finances of two or more businesses or individuals.-History:...
. But under a gold standard
Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard...
, transactions in the financial account would be conducted in gold or currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
convertible into gold
Gold
Gold is a chemical element with the symbol Au and an atomic number of 79. Gold is a dense, soft, shiny, malleable and ductile metal. Pure gold has a bright yellow color and luster traditionally considered attractive, which it maintains without oxidizing in air or water. Chemically, gold is a...
, which would also affect the quantity of money in circulation in each country.