The Price-Specie-Flow Mechanism

The price-specie-flow (PSF) mechanism is the extension of the quantity theory of money (QTM) to a multi-country scenario. Proponents of the end-neutrality of QTM often implicitly assume a closed economy. But when nations trade amongst each other, the injection of monetary units in a nation can, instead of putting upward pressure on local prices, promote imports, and thus cause an outflow of money, in the short term. The price-specie-flow mechanism accounts for these dynamics.

The PSF mechanism posits the following. If the money supply in Country A increases, it will have two effects, (1) local prices will rise, and (2) imports will increase (because people have more money to spend). Because of rising local prices, exports of Country A will fall. This, combined with rising imports, will lead to a negative trade balance for Country A. As a result, money (specie) will flow out of Country A to pay for the deficit.

The outflow of specie will reduce the money supply in Country A. Thus, (1) local prices will fall, and (2) imports will decrease (because people have already spent that additional money). Reduced prices will make exports more competitive. Rising exports and falling imports will counter the previous negative trade balance until it reverses entirely.

PSF and the Gold Standard

During the gold standard era, when nations were united under the same money, the PSF mechanism provided an excellent resolution to the problem of trade imbalances. Countries with trade surpluses experienced gold inflow, which resulted in an increased money supply, and thus, an upward pressure on local prices. Over time, this would reduce the competitiveness of their exports. Countries with trade deficits experienced the opposite: gold outflow contracted money supply and put a downward pressure on local prices, which would, over time, increase their export competitiveness. All this balancing of trade would occur without intervention from governments or central banks.

The PSF mechanism would efficiently propagate price signals throughout economies operating under the gold standard and exert an equalizing influence on the prices of goods and services in these nations. Striving for price (and, thereby, export) competitiveness drove economies to harness their natural competitive advantages to the fullest. A complex and intricate global economy was thus formed.

The world wars and subsequent dissolution of the gold standard destroyed this mechanism and the resulting economic benefits. Today, without the discipline of the gold standard, governments routinely implement inflationary policies, with inevitable deleterious consequences. Balance of payments lack automaticity; they are dominated by central bank actions. Industry specializations across different geographical regions are affected less by price signals and more by the policies taken by different governments.

Quotes

  1. “With gold the common currency base, the money and credit supply of each country could be expected to adjust itself, except for short-term fluctuations, to the international flow of gold, and vice versa. In each country, interest rates, the flow of capital into investments, money incomes, and price levels were affected in the long run by the flow of gold. This ‘automatism’ of the gold standard was perhaps its most significant feature. Money supplies and national trends of business activity were essentially interdependent and ‘synchronized,’ due to the ‘discipline’ of the balance of payments—that is, the necessity, under the gold standard, of adjusting the domestic money supply and interest rates to the flow of gold.” — Melchior Palyi, The Twilight of Gold, Chapter 1C.

References

  1. Melchior Palyi, The Twilight of Gold (1972), Chapters 1 and 2.
  2. Murray Rothbard, David Hume and the Theory of Money (1995).