The new situation of floating exchange rates made for a dramatic change in the adjustment regime. With the gold standard, and with all fixed-rate regimes, adjustments of trade imbalances take place through the mechanism of price and wage shifts, and mobility of factors of production – in particular, labor. We have discussed this at length above. But with floating exchange rates, adjustments take place in an entirely different manner. Rather than individual wages and prices advancing or declining, the entire wage and price structure of the economy rises and falls, by means of the exchange rate of the national currency vis-à-vis foreign currencies.
Milton Friedman’s article, “The Case for Flexible Exchange Rates,” is the classic exposition of the advantages of floating rates vis-à-vis fixed rates. Using the analogy of daylight savings times, Friedman provided a nice analogy explaining the advantage to this manner of adjustment:
The argument for flexible exchange rates is, strange to say, very nearly identical with the argument for daylight saving time. Isn’t it absurd to change the clock in summer when exactly the same result could be achieved by having each individual change his habits? All that is required is that everyone decide to come to his office an hour earlier, have lunch an hour earlier, etc. But obviously it is much simpler to change the clock that guides all than to have each individual separately change his pattern of reaction to the clock, even though all want to do so. The situation is exactly the same in the exchange market. It is far simpler to allow one price to change, namely, the price of foreign exchange, than to rely upon changes in the multitude of prices that together constitute the internal price structure.
Not only is it far simpler to have only one price change rather than “the multitude of prices,” it is far less painful. Inflation or deflation is not directly transmitted into the economy; there is a shock-absorbing effect that enables the economy as a whole to adapt to adverse conditions over time. And depending on the level of national-economic self-reliance (i.e., the share of domestic production supplying total consumption) there need not be any serious repercussion. But where structural flaws exist, they still need to be addressed. Even so, there is no guarantee that adaptation will take place; these structural problems may be left to fester, leading to long-term inflationary or deflationary pressures. The point is, there is time to adapt, by measures such as changes in taxation and fiscal policy, or by import replacement (in the case of a depreciating currency). Jane Jacob’s above-mentioned book goes into detail on this topic.