David Hume (1711–1776), one of the most famous philosophers in Western civilization, was the first to give a thorough and complete explanation of the gold-specie-flow mechanism, which is the automatic adjustment mechanism that balances the inflow and outflow of gold under an international gold standard.
On a gold standard a country’s money supply, including paper money, is directly proportional to domestic gold holdings, including bullion and gold specie. When a country imports goods from abroad, making payment causes gold to flow out of the importing country. When a country receives payment for goods exported abroad, gold flows into the country. In addition, investments in a foreign country cause gold to flow out, destined for the country receiving the investment. When a country attracts foreign investment, gold flows in to pay for the investment.
David Hume addressed the problem of what happens when the outflow of gold, owing to imports and investments in foreign countries, is unequal to the inflow of gold from exports and foreign investment attracted from abroad. He developed the gold-specie-flow mechanism to explain the forces that bring the outflow of gold into balance with the inflow of gold, stabilizing domestic money supplies.
If gold outflows exceed gold inflows, domestic money supplies dwindle, putting downward pressure on domestic prices. As domestic prices fall, domestic goods become cheaper relative to imported goods, decreasing gold outflows from imports. Also, falling domestic prices lower the prices of domestic goods in export markets, increasing gold inflows from exports. Therefore, imports decrease and exports increase, closing the gap between the gold outflows and gold inflows.
If gold inflows exceed gold outflows, domestic money supplies balloon, putting upward pressure on domestic prices. Rising domestic prices render domestic goods less competitive in export markets, decreasing gold inflows from exports. Also, rising domestic goods prices lift the price of domestic goods relative to imported goods, increasing gold outflows from imports. Therefore, imports increase and exports decrease until the gap between gold inflows and gold outflows has closed.
Hume’s theory of the gold-specie-flow-mechanism helped supply the theoretical foundation of the gold standard as a stabilizing force in monetary affairs.