Milton Friedman

Milton Friedman (July 31, 1912 – November 16, 2006) was an American economist and nobel laureate.

In his "The Case for Flexible Exchange Rates," Friedman argues that fixed exchange rates impede free trade or trade liberalization. Fixed exchange rates constrain the policy actions policy makers can take in order to ensure that the current account and the capital account balance out. The following excerpt articulates why a fixed exchange rate regime impedes trade liberalization:

“It cannot be too strongly emphasized that the structure and method of determining exchange rates have a vital bearing on almost every problem of international economic relations…The only other alternative to movements in exchange rates is direct control of foreign trade. Such control is therefore almost certain to be the primary technique adopted to meet substantial movements in conditions of international trade so long as exchange rates are maintained rigid. The implicit or explicit recognition of this fact is clearly one of the chief sources of difficulty in attempts to achieve a greater degree of liberalization of trade in Europe…”

Friedman points out that with a fixed exchange rate regime states can only achieve a balance of payments by either influencing the cost of domestic-foreign transactions through things like subsidies and tariffs, or by allowing the domestic price level to rise and fall by adjusting the interest rate. He argues that allowing exchange rates to be determined by the market would ensure a balance of payments because exchange rates would adjust automatically to ensure the current account and the capital account balanced out.

Friedman was an advocate of flexible exchange rates as opposed to fixed exchange rates because he believed that liberalized trade is not possible with fixed exchange rates.

If all exchange rates were fixed, countries would be reliant on each other to progress economically. For instance, Friedman warns, “under a system of rigid exchange rates and unrestricted trade, no country can attain this objective [of economic growth] unless every other important country with which it is linked directly or indirectly by trade does so as well”. Countries must give themselves a change to succeed economically without depending on foreign influences if they want to have liberalization of trade. If all countries are tied together, with fixed exchange rates, then if one country starts to economically decline dramatically, all other countries will be dragged down with it. In the past, many countries were fixed on the gold standard, but it was not the most efficient fixed exchange rate because it created many economic problems. If countries agree to a type of fixed exchange rate, like the gold standard, they would to vow to follow it with unwavering cooperation, which rationally, does not happen.

Instead, Friedman argues for flexible exchange rates on the basis that this system “eliminates the necessity for such far-reaching co-ordination of internal monetary and fiscal policy in order for any country separately to follow a stable internal monetary policy”. He does agree that the economic market won’t naturally work out perfectly without slight tweaks of policy, but he concludes that, “the aim of policy is not to prevent such changes from occurring but to develop an efficient system of adapting to them—of using their potentialities for good while minimizing their disruptive effects”. Flexible exchange rates, to Friedman, allow for slight changes through economic policy, without strangling the world economy through its international economic connections.

References

1. Friedman, Milton. “The Case for Flexible Exchange Rates.” In Essays in Positive Economics, 157-203. Chicago: University of Chicago Press, 1953. Parts IV-V p. 196-197.