Modern Trade Theory

4.1. Modern trade theory

4.1.1.The Mercantilists

During the period 1500-1800, a group of writers appeared in Europe who was concerned

with the process of nation building. According to the mercantilists, the central question was

how a nation could regulate its domestic and international affairs so as to promote its own

interests.

The solution lay in a strong foreign-trade sector. If a country could achieve a favorable trade

balance (a surplus of exports over imports), it would realize net payments received from the

rest of the world in the form of gold and silver. Such revenues would contribute to increased

spending and a rise in domestic output and employment. To promote a favorable trade

balance, the mercantilists advocated government regulation of trade. Tariffs, quotas, and

other commercial policies were proposed by the mercantilists to minimize imports in order

to protect a nation's trade position.

By the eighteenth century, the economic policies of the mercantilists were under strong attack.

According to David Hume's price-specie-flow doctrine, a favorable trade balance was possible

only in the short run, for over time it would automatically be eliminated. To illustrate, suppose

England were to achieve a trade surplus that resulted in an inflow of gold and silver. Because

these precious metals would constitute part of England's money supply, their inflow would

increase the amount of money in circulation. This would lead to a rise in England's price level,

relative to that of its trading partners. English residents would therefore be encouraged to

purchase foreign-produced goods, while England's exports would decline. As a result, the

country's trade surplus would eventually be eliminated. The price specie-flow mechanism thus

showed that mercantilist policies could provide at best only short-term economic advantages.

The mercantilists were also attacked for their static view of the world economy. To the

mercantilists, the world's...