Friday, March 27, 2009

david Hume-The price-specie-flow mechanism (2)

1- There must be some formal link between money and prices ,such as that provided in the quantity theory of money when full employment is assumed:
Ms v = p y
where: Ms=the supply of money
v= the velocity of money ,or the rate at which money changes hands
p= the price level
Y= the level of real output
if one assumes that the velocity of money is fixed by tradition and institutional arrangements and that Y is fixed at the level of full employment,then any change in the supply of money is accompanied by a proportional change in the level of prices.
2- Demand for traded goods is price elastic .this is necessary to ensure that an increase in price will lead to a decrease in total expenditures for the traded goods in question and that a price decrease will have the opposite effect.if demand is price inelastic ,the price-specie-flow mechanism will tent to worsen the disequilibrium in the trade balance . however,demand elasticities tent to be greater in the long run than in the short run as consumers gradually adjust their behavior in response to price changes .Hence,even though the price-specie-flow mechanism may be "perverse" in the short run,Hume is result is likely to occur as time passes

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