Explain what is meant by the term ‘price-specie’ flow mechanism PDF

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Discuss the view the Mercantilists discovered the price-specie flow mechanism but chose to ignore it because it undermined their main arguments.
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Explain what is meant by the term ‘price-specie’ flow mechanism. Discuss the view the Mercantilists discovered the price-specie flow mechanism but chose to ignore it because it undermined their main arguments. devastating critique known as the specie-flow mechanism. Scottish philosopher and political economist David Hume (1711-1776) pointed out that the very success of a nation's mercantilist policies—a trade surplus—would set in motion forces that would tend to reverse the trade surplus, all through the normal operation of markets. Allowing for the free flow of money, at this time mostly gold, it was argued, would tend to result in a balance of trade equilibrium. The process: (1) Inflow of gold in England. Only gold can be used as a medium of exchange. (2) The money stock increases in the same proportion (a fiat money fractional reserve system would magnify the increase). (3) Price level increases. (Including export goods) (4) Foreign countries’ (with less money) prices decrease, buy less from England. (5) British citizens buy more foreign goods, less British goods. (6) English trade surplus becomes a deficit. (7) Gold flows out, money stock decreases, prices decrease, surplus again!

Introduction: briefly state what price-specie flow mechanism is and what mercantilists is. Say because of the ideas of mercantilism, they chose to ignore PSFM.  The price-specie flow mechanism is a model developed by David Hume to explain how trade imbalances can be automatically adjusted under the gold standard. In its original form, the model assumes that only gold coins are circulated and the role of central bank is negligible.  This mechanism is best illustrated using an example. Suppose there is a trade deficit – there are more imports than exports. This results in an outflow of gold, subsequently decreasing domestic money supply. Then the price level falls, which in turn makes 2 domestic goods relatively cheaper than foreign goods. This leads to more exports and less imports thereby self-correcting the trade imbalance. First paragraph: explain the PSFM, the theory behind it and the economists who talked about it.  Price-Specie Flow Mechanism (logical argument by David Hume) – when exports are greater than imports so there is a trade surplus/positive balance of trade. This causes a net inflow of funds (“specie”) which in turn makes the exchange rate higher.  Hume argued that in countries where the quantity of money increased, inflation would set in and the prices of goods and services would tend to rise while in countries where the money supply decreased, deflation would occur as the prices of goods and services fell.  Exports fall because good coming too expensive (Mun states this) and imports rise (trade surplus falls). “Normal” prices return.  This acts to equalize process across countries and automatically bring international payments into balance. Second paragraph: explain the ideas of mercantilism and the economists who backs it up.

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Thomas Mun, writing as early as 1630, had realised that an inflow of bullion raises domestic prices and the “selling dear and buying cheap” tends to turn balance of trade against a country. Cantillon and Hume restated this argument in the eighteenth century and for a century or more this ‘specie-flow mechanism’ provided the definitive refutation of mercantilist principles. (Spiegel) 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. Based on a fixed quantity of gold – Mercantilists believed obtaining and accumulating gold was best. Locke expressed that ‘riches’ means not just more gold and silver but more in proportion to other countries. Mercantilists subscribed to the view that the economics interests of nations are mutually antagonistic, as if there were a fixed quantity of resources in the world that one country could acquire only at the expense of another; the economic growth of nations was a zero-sum game. This goes against the PSFM because by obtaining the majority of wealth in the world, other countries have less money to purchase their goods and exchange rate would be too high. Mun (1571-1641) was one of the first mercantilists, advised to have restraint in the domestic use of imported commodities so that greater quantities will be available for export, stimulation of domestic production of import-competing goods and of fisheries, and avoidance of the common excess of food and clothing(Spiegel) For example, the use of English Coal (which contained a high energy capacity) and the use of one’s own ships for exports. Francis Bacon 1616, the doctrine says that if the “exportation of home commodities be more in value than the importation of foreign, we shall be sure that the stocks of the Kingdom shall increase, for the BoT must be returned in money or bullion.” “to sell more to strangers yearly than we consume of theirs in value,” – Mun This restricts foreign countries ability to purchase goods and forces them to pay at “monopoly prices”. If imports were needed, then it was better to buy cheaply from far countries than from merchants in neighbouring merchant cities. However, Munn did not take into account the transport costs. However, this goes against PSFM because it would cause the exchange rate to increase.

Third paragraph:  Mun emphasised on the fact that money must not be left idle and thus must be employed as capital funds; turned into merchandise and again into money  Mun’s idea is as close as it can get to the specie-flow theory of international prices, however this theory sees using proceeds from exports to allow for domestic prices to rise rather than Mun’s idea of proceeds being sent out again.  The mercantilists did not take account of Hume’s self-regulating specie-flow mechanism because they did not interpret the quantity theory of money as he did.  Quantity theory of money- “money stimulates trade”- increase in money supply increases demand.

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Unlike the mercantilists, Hume does not consider the volume of world trade as fixed. Hume- “I pray for the flourishing commerce of Germany, Spain, Italy, and even France itself”- foreign countries more wealthy means they can buy more British goods. (Spiegel) We can see that the mercantilists chose to ignore the price-specie flow mechanism because it clearly goes against their policies and idea of accumulating the most wealth against other countries because they believed the amount of wealth in the world was fixed.

Conclusion: sum everything up.  To conclude, prices were the main mechanism for adjustment between classical gold standard countries which faces inflows and outflows over-time.  Hume, being a believer in free trade and an opponent of mercantilism, spoke about this price-specie flow mechanism, which consequently went against mercantilist idea that a nation should strive for a positive balance of trade.  Hence, mercantilists, upon discovering this mechanism, decided to ignore it because it went against their principle argument, which according to Spiegel suggest that Mun so often stated that an export balance will bring specie into the country....