How Did the Gold Standard Really Work? A Comparison of the Price-Specie-Flow Mechanism and the Monetary Approach to the Balance of Payments

Abstract

The price-specie-flow mechanism (PSFM) is a theory of adjustment of balance of trade and gold flows in response to deviations in relative price levels across countries under a gold standard. The PSFM is central to quantity-theoretic discussions of economic fluctuations under a gold standard as well as analysis of whether central banks followed the of game of gold standard. The PSFM is often standard working assumption when it comes to gold standard adjustment. However, at least since Adam Smith there has been an alternative to PSFM that has come to be known as monetary approach to balance of payments. The distinction between PSFM and monetary approach have important implications for both quantity-theoretic explanations of economic fluctuations as well as interpretation of so-called rules of game. In this paper, we outline and test empirical predictions of each theory to determine which is more accurate. The evidence is mixed, but largely favors monetary approach to balance of payments.