Question

Explain David Hume's theory of automatic adjustment for balance of payments disequilibria.

Answer 1

David Hume's theory suggested his approach on the automatic adjustment process of balance of payments. He refutes the view of mercantists that change in exchange rate or tariffs were needed for maintaining an appropriate quantity of money. He provided an explanation on the self-adjusting mechanism of balance of payments as any deficit or surplus would be eliminated automatically with the changes in domestic price levels. The countries with surplus payments will experience inflation; and thus suffers a loss of competitiveness, a fall in net exports, and causing a decrease in the surplus. The opposite will be applicable to the countries that experiences payments deficit. He argued that the disequilibrium in balance of payments causes an increase in money and price in the surplus nation and reduces the money and supply in the deficit nation. Consequently shifting the expenditure from the surplus nation to the deficit nation and eventually restores the equilibrium