Introduction

Earlier arguments in defense of floating exchange rates often contained high hopes that by allowing the exchange rate to adjust naturally in response to the ebb and flow of international payments, there would be no need for the government to intervene to correct balance-of-payment disequilibria. International payments adjustment would become virtually automatic. This was taken to imply, among other things, that there would be less likelihood that protectionist policies such as tariffs and quotas would be used. In other words, floating exchange rates should lead to free trade, or at a minimum, freer trade within the world economy.

Behind the earlier textbook arguments for the linking of free trade to floating exchange rates were two closely related assumptions. First, it was presumed that exchange rates would adjust toward market equilibrium in a smooth and orderly fashion. Milton Friedman argued that destabilizing speculators would on average incur losses while stabilizing speculators made profits – thus ensuring that stabilizing speculation would predominate.