ABSTRACT
This chapter examines the balance-of-payments adjustment process under the assumption of fixed exchange rates. One mechanism for the elimination of payments surpluses or deficits is the specie flow mechanism. This system, associated with David Hume, is automatic. In other words, the restoration of equilibrium does not depend on the decisions of a central bank or another government official. Under specie flow, national currencies are backed completely by gold, which is the only foreign exchange reserve asset. This means that the money supply of a country is solely determined by the stock of gold held by the central bank or government. A balance-of-payments surplus means that gold flows into the country’s central bank, which increases the money supply. The higher money stock lowers domestic interest rates, generating capital outflows, and reducing any surplus in the capital account. The price level also increases causing imports to rise and exports to fall (which affects the current account). The level of economic activity and income also rises, which raises imports. If, however, the economy is operating close to full employment, real output and incomes cannot rise, so inflation increases. This adjustment process continues until equilibrium is restored in the balance-of-payments.
