Adam Smith's Theory of Money and Banking

Abstract

This paper resolves a long-running debate in the economics literature – the debate over Smith’s theory of money and banking – and thereby revolutionizes current understanding about the history and evolution of monetary analysis. Smith did not present either the real-bills theory or a price-specie-flow theory of banknote regulation, as generally presumed, but rather a reflux theory based upon the premise that the demand for money is fixed at a particular nominal quantity. This theory denies that an excess supply of money can ordinarily make it into the domestic nominal income stream or influence prices or employment. The essence of Smith’s theory is not, as the real bills interpretation would suggest, that banknotes are elastic credit instruments that accommodate changes in demand; rather, it is that the supply of money, including banknotes, is forced to regulate itself to a fixed demand. And unlike Hume’s price-specie-flow mechanism, Smith’s specie-flow mechanism does not point to changes in domestic relative to world prices as the factor motivating the trades that restore monetary equilibrium.

Keywords: Adam Smith, Price-Specie-Flow Mechanism, Real Bills Doctrine, Free Banking, Law of Reflux, Monetary Approach to the Balance of Payments

JEL Classification: B12, B31