Price Specie Flow Mechanism and the Monetary Approach to the Balance of Payments as Theories of International Adjustment

Abstract

When thinking about how the gold standard worked, economists tend to focus on issues of price level determination and the self-correcting role of gold production.1 Less attention is usually given to the international adjustment mechanism. However, the international adjustment mechanism is critical to understanding how the gold standard actually worked. To the extent that international adjustment is discussed, these discussions generally invoke the price-specie-flow mechanism (PSFM). There is also a focus on the corresponding “rules of the game” of the gold standard. Less commonly discussed is an alternative mechanism of international adjustment, which is known as the Monetary Approach to the Balance of Payments (MABP). In this chapter, we explain that there are two competing theories of price level determination under the gold standard, the Quantity Theory of Money and the Classical Theory. The PSFM is critical to the Quantity Theory. The Classical Theory relies on the MABP. An empirical examination of the international adjustment mechanism is therefore important for understanding how the gold standard actually worked and whether there are “rules of the game” that needed to be followed. We argue that, despite its popularity, there is little evidence that the PSFM is an appropriate description of international adjustment under the gold standard. However, there is evidence to support the MABP. This has important implications about price level determination and the interpretation of historical events, such as the Great Depression.