The Four-Pronged Mechanism

Now consider Hume’s theory of international payments equilibrium. Suppose that America runs a large trade deficit and begins to lose gold. According to the quantity theory of prices, this loss of gold reduces America’s money supply, driving down America’s prices and costs..As a result, (1) America decreases its imports of British and other foreign goods, which have become relatively expensive; and (2) because America’s domestically produced goods have become relatively -inexpensive on world markets, America’s exports increase.

Figure 29-7 illustrates the logic in Hume’s mechanism. Make sure you can follow the logical chain from the original deficit at the top through the adjustment to the new equilibrium at the bottom.

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