Price–specie flow mechanism

The price-specie-flow mechanism is a logical argument by David Hume against the Mercantilist (1700-1776) notion that a nation should strive for a positive balance of trade, or net exports, whose value today is recorded in the current account. Under a gold standard, 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. Mr. Hume argued that when a country in a gold standard had a positive balance of trade, gold would flow into the country in the amount that the value of exports exceeded 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 exceeded 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 quantity of money in circulation would rise in a country with a positive balance of trade and fall in a country with negative balances of trade. Using a theory called the quantity theory of money, Hume then said that in countries where the quantity of money increased prices of products would tend to rise and in countries where the money supply decreased prices of products would tend to fall. As a result, the higher prices in the countries with positive balances of trade would be able to export less and would import more, reducing their balances of trade. The lower prices in countries with negative balances of trade would be able to export more and would import less, increasing their balances of trade. These adjustments of prices and the balances of trade were predicted to continue until the balance of trade was reduced or increased to zero in each nation.

The price-specie-flow mechanism can also be applied to the entire balance of payments, which accounts not only for value of the balance of trade and similar transactions, called the current account, but also the financial account, which accounts for flows of 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.