Price-specie-flow Mechanism

David Hume first proposed this argument, which analyzes how trade functions between countries on the gold standard. Hume postulated that when a country has a positive balance of trade due to lower prices and less circulating money (in all cases, Hume equates "money" with "gold"), money begins to flow into the country; their goods would, at this point, appear cheaper and more attractive to foreign countries. Therefore, the amount of money in this country increases. Conversely, Hume predicted that when a country has more money and the price of goods become inflated, the country experiences a negative balance of trade. In this situation, a country with more money would, over time, see the net amount of money decrease.

Hume saw this process of leveling as a constant cycle which consistently re-reestablished equilibrium of money supply as countries fluctuated between positive and negative balances of trade. He compares money to water in that, “All water, wherever it communicates, remains always at a level”; when connected through channels, will naturally reach the same level everywhere."  The only exception to this rule is when there are “barriers” in the water, representing the case of lack of communication between states.

Hume recognized that the most favorable point in time for a country is the point at which the acquisition of money and the rise of prices that the increasing quantity of gold and silver cause have not yet initiated an increase in labor prices (and therefore reduced exports). He said that this can be explained by the fact that it takes time for money to trickle down to the employees of those traders and manufacturers who initially procure the increased revenue. It is only when these employees start spending more money en masse that the economy drastically changes.

Limits to the Model

As with all simple general equilibrium models, Hume's Price-Specie Flow Mechanism, while elegant, has limitations. In Hume's case, his model fails to incorporate two important aspects of the 19th century international monetary system. First, Hume's model did not account properly for capital flows. Hume's model assumes that gold or money flows from one country to the next in exchange for goods and services. This, however, does not properly take into account the varied nature of capital flows. As international financial markets developed and became more sophisticated, Hume's model became less applicable. Net capital flows were often larger than the balance of commodity trade. Hume's model, however, did not address the relationship between these flows and things like interest rates or bank activity. These interactions are crucial in understanding how the international monetary system hung together. Second, Hume's model predicts large-scale shipments of gold across borders in response to changes in domestic price levels. Empirically, however, Hume's model suffers from "the absence of international gold shipments on the scale predicted by the model."