I really love the atmospheric style of the FREE music but I like the approach of each area having it's own music more.
Changing the music based on where you are in the story is a very clever idea but there are problems. For example, I really like FREE 1 but you can only hear it early in the game, then never again. On the other side we have FREE 7, wich is the only thing you'll hear for days later in the story. Being stuck with something and having no chance to hear certain tunes ever again is actually a pretty flawed system if you think about it.
Having music based on the area you're in ensures you don't have to listen to something for days everywhere and you can easily go back to your favorite music by just going to its area. It's also just a regconition thing. I'm sure everyone that played Shenmue II a couple of times will instantly have vivid images of the area when for example the South Carmain Music plays. Having different music at night also greatly enhances the mood. Shenmue very rarely changes the music after the nighttime sequence and pausing the current FREE music just to go back to it again afterwards is just wasted potential of the soundtrack.
I'm clearly for the Shenmue II style here, the reasons I stated above make it obvious why. But they could expand it by having story based music playing in every area at key points in the story to heighten the tension. Shenmue II actually kinda does that too already, when you're looking for Ren at Pigeon Park.