Price-Specie-Flow

International trade can be mutually beneficial to both trading partners, as we have seen, because the two different countries have different conditions of production. Thus they have different relative costs, so that each one has a comparative advantage in exporting at least one good. But another major difference between countries is that different countries often use different monetary units. The U. S. uses Dollars, Japan uses Yen, and Italy uses Lira -- though European countries, including Italy, plan to move to a common currency soon. How do these different monetary units work in international trade?

When gold coins were the medium of exchange, gold could be shipped like any other commodity, and coins could be melted down and restruck with a new king's picture on them. However, the shift to a largely fiduciary money system complicated things somewhat.

Nevertheless, some observers wondered if a country would always have enough gold coin to carry on business. By the middle of the Eighteenth Century economists and philosophers had studied the relationship between prices and gold shipments and expressed their findings in something called the "price specie flow mechanism." We'll see how that worked in a moment.

Recall, the British monetary system was re-engineered by David Ricardo after the Napoleonic Wars. Ricardo designed the new monetary system to work through the price-specie-flow mechanism.

The international monetary system that David Ricardo designed for nineteenth century Britain worked like this:

If Britain imported more than it exported, pound notes would be turned in for gold at the Bank of England, and gold would flow out of the country.
With less gold reserves, the bank of England would be forced to cut the number of Pounds in circulation.
This would reduce the British price level, making exports cheaper and imports more costly in Britain.
This would reduce British imports and increase their exports, restoring balance.

Thus, the outflow of gold (specie) leads to a decrease in the money supply. Ricardo, and many other economists, believed that a reduction in the money supply would reduce (deflate) the price level. This would make Britain's exports cheaper, and her imports relatively more expensive, so lead to increased exports, decreased exports, and thus to a balance of exports and imports.

Exchange Rates, Supply and Demand.