Price specie flow mechanism

Price specie flow mechanism

The Price-specie-Flow Mechanism is a logical mechanism created by David Hume which dispelled the Mercantilist (1700-1776) notion that a nation can have a continuously favorable balance of trade. Under the rules of the Gold standard,each nation’s currency consisted either of gold itself, or of paper currency fully backed(convertible) by gold. Consequently, in the absence of any sterilization, money supply would fallin the deficit nation and rise in the surplus nation as external balances were settled by payment ingold. Since the popular economic theory at the time for explaining monetary equilibrium andformation of domestic prices was the so-called quantity theory of money, a fall in the moneysupply would cause internal prices to decline, just as an increase in money supply would causeprices to rise in proportion. As a result, the relative prices of the deficit nation would fall,causing its exports to rise and imports to fall. The opposite changes took place in the surplusnation. And this process of adjustment through prices was expected to continue until balance ofpayments equilibrium (current A/C only) or external balance were fully restored in each nation.

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