What are the critical assumptions of the price specie flow mechanism What
What are the critical assumptions of the price-specie-flow mechanism? What happens to the trade balance in a surplus country if the demand for traded goods is price inelastic? Why?
What are the critical assumptions of the price specie flow mechanism What
The Correct Answer and Explanation is :
The price-specie-flow mechanism, introduced by economist David Hume in the 18th century, explains how adjustments in the trade balance and the flow of specie (gold and silver) impact the economies of different countries engaged in international trade. The mechanism operates within the context of the classical gold standard system, where money supply is directly tied to the amount of precious metals (specie) held by a nation.
Critical Assumptions:
- Fixed Exchange Rates: The system assumes that exchange rates are fixed in terms of specie, meaning that currencies are convertible to gold or silver at a specific rate.
- Perfect Capital Mobility: The flow of specie is assumed to be free from any restrictions, meaning that specie can move across borders without hindrance.
- Price Flexibility: Prices are assumed to be flexible, meaning they can adjust to changes in demand and supply. This ensures that trade balances can adjust through changes in price levels.
- Monetary Neutrality: It assumes that changes in the money supply will only affect the price level and not real output in the long run.
- Trade Balance Adjustment: The mechanism assumes that a trade surplus or deficit will automatically correct itself over time as specie flows in or out of the country, affecting the price level and thereby altering the trade balance.
Impact of Inelastic Demand for Traded Goods in a Surplus Country:
If the demand for traded goods in a surplus country is price inelastic, an increase in the money supply (due to an inflow of specie) would lead to higher domestic prices. However, because the demand for these goods is price inelastic, foreign demand will not decrease significantly despite the price rise. As a result, the country will continue to export the same amount of goods despite the price increase, and the trade surplus will persist.
In this scenario, the price-specie-flow mechanism’s self-correcting mechanism is weakened because the demand for exports does not respond as expected to price changes. This can prevent the surplus from being corrected through trade balance adjustments, leaving the surplus country with prolonged favorable trade conditions.
Let me generate an image that explains this concept further.
The diagram above illustrates the price-specie-flow mechanism and how changes in specie flows can impact a country’s trade balance. It also shows the effect of inelastic demand on trade in a surplus country, helping to visualize the dynamics between the flow of specie, price changes, and trade balance adjustments.
Let me know if you’d like to explore further or if you need any clarifications!
