Law and Economics

Posted: August 26th, 2021

Law and Economics

Student’s Name

Course

Date

Law and Economics

Part 1

The science of economics has attracted considerable attention among scholars, primarily because of the many historical events that have centered on economics. One such event was the great depression of 2008. According to Cooter and Thomas, the science of economics is concerned with the distribution of the limited natural resources and energies at the disposal of humankind to satisfy their unlimited needs to the best extent possible[1]. However, it is nearly impossible to meet and satisfy all the needs and wants of all people. Asa result, Cooter and Thomas suggest that economic optimum is attained when it is impossible to transfer the human energies and natural resources from the satisfaction of one need such as food to the satisfaction of another want such as shelter¹. However, this issue can be resolved.

The problem can be addressed on the condition that all the natural resources of an economy, the size, and attributes of a given population, the private property of each person, their wants, and order of preference are known. With this information, the law also comes into play. The legal framework of a given country protects and upholds the use of natural resources, thereby safeguarding the economic conditions for the benefit of all people¹. From this analysis, it is evident that the fields of law and economics are intertwined, and one cannot be effective without the other. Therefore, law and economics have some connections, resulting in some negative and positive effects in a business environment.

Methodologies in Law and Economics

Economics and law are related in many ways. For instance, they both use integrated methods and approaches in their analysis of the world. According to Aaken, the field of economics avails a systematic model in the prediction of the influence of legal endorsement of human conduct[2]. Consequently, the two disciplines provide a blueprint for the courts for solving matters related to the legal system. The models of economics also shed light on the effects of the law, while at the same time determining the impact of regulating economic performance. Hence, the efficiency of statutory regulations is determined. The evaluation of the law has also gone a long way in allowing policymakers to determine and predict the effect of a profit-maximizing sanction on economic theories[3].

The relationship between economics and law has both positive and negative effects. Concerningthe positive effects, the behavioral theory in economics is used to predict the response of businesses or people to a given challenge. For example, Liviu and Neamţu suggest that the rule of supply and demand helps one understand why people’s consumption levels are low when prices are high[4]. The concept of law and demand can be explained by an analysis of marketing and management on the demands and the sensitivity of clients. The concept can also be explained based on supply and business policies established by companies in a competitive market. According to Liviu and Neamţu, economists posit that demand develops based on the function of demand, following the formula[5];

C_x = a – bp_x.

C_x = demand

P_x = price

The function that characterizes the demand is linear⁵. Figure 1 shows the demand function.

Figure 1: Demand Function ⁵

Legal sanctions can also be assumed to act like prices when the law of demand is in question. Good behavior is endorsed, while bad behavior is discouraged. The relationship or association between law and economics contribute to a positive influence, in that, before legal sanctions are expressed, a person can assess and tell if the intended objectives will be attained[6]. For example, the law suggests that bad conduct in economics is punishable with a fine and hence discouraged. Consequently, judges tend to uphold rules and regulations that promote economic progress and desirable social behavior[7]. Economics, on the other hand, provides a logical method for evaluating the effectiveness of a given policy. Therefore, when the two disciplines co-exist, their functions are complemented.

Law, Economics, and Implementation of Policies

Law and economics also influence the implementation of policies when the property of an individual is involved. A legal system is expected to provide unambiguous definitions of property rights. Therefore, for each asset, every party must be capable of determining the owner unambiguously. The set of rights of ownership should also be clear. Ideally, it is expected that in cases where there is a disagreementover the rights of ownership, the right should be given to the individual with the highest value of the asset[8]. According to the Coase theorem, if rights can be transferred and transactions are insignificant, then there is no need for defining property rights because the involved parties8 can trade them.

In many scenarios, the people who own the matter of the right. Also, there is a possibility of transaction costs werezero; if rights are not allocated accurately, then a costly transaction must take place to remedy the misallocation. At the same time, if the transaction costs are higher than the value of moving a resource to the rightful owner, there is usually no mechanism for making corrections[9]. Such an event can occur in any economy. One such extreme exampleis Russia. In Russia, the courts have not yet been able to arrive at clear definitions of property rights. The people in control of many businesses and firms are usually not the real owners⁹. Therefore, the people in control of these businesses and firms cannot sell them, and neither can they keep the proceeds. This environment promotes the inefficient use of assets. For example, valuable raw materials can be sold for prices way below the market price and proceeds can be deposited in places far away from the country⁹. In such a case, the Coase theorem does not apply. Because of such an unfortunate event, Russia and other countries suffering from the ambiguous definition of property rights have emphasized the development of a legal system that will go a long way in creating a strong market economy⁹. In essence, law and economy are closely related and play a significant role in the development of policies.

Economics and Contract Law

Contract law too displays the relationship between economics and law. Economics as a field focusses on exchanges, and hence the law governing transactions is crucial. The doctrines of contract law are in line with achieving efficiency in economics[10]. The study of economics and contract law has also shown that people must be allowed to write their contracts.

Consequently, the courts have been left with the responsibility of enforcing the terms of an agreement in normal circumstances. However, it is worth noting that the courts do not have the responsibility to enforce contracts if performance is considered inefficient[11]. Instead, the courts are only to ensure damages are compensatedfor in such circumstances.

Contract laws are also established to reduce opportunistic challenges. The challenges and problems associated with opportunism arise in cases where two people or parties agree on terms, and one makes irreversible investments in keeping up their side of the bargain[12]. For instance, a firm can invest in building a road to a market, consequently making prior arrangements to transport incoming and outgoing products at a fixed price. On completion of the road, the owner of the market can fail to abide by the terms of the contract and prefer cheaper means. In such a case, the company that builds the road will accept the offer if the newly proposed rate has exceeded the incremental costs of the road. At the same time, this move will mean that the company will not receive the full return that was supposed to invest in a worthwhile venture. Therefore, the doctrines of contract law go a long way in reducing the adverse effects of a breach of contract¹². In this case, the relationship between economics and law is beneficial since parties are protected.

However, the doctrines of contract law do not always result in positive consequences. According to Chen-Wishart, in some cases, the persons involved in a contract will go to the extent of specifying damages¹². The damages are not guaranteed to be paid if they are too high. Failures to abide by the agreed terms of a contractconstitute a challenge that scholars are still studying[13]. As a result, the positive effects associated with law and economy, in this case, seem to be violated.

Economics and Tort Law

The relationship between law and economics can also be explored using the concept of tort law. According to Carty, tort law is meant for protecting property rights from unintentional or intentional harm[14]. The purpose of tort law in economics is to ensure that criminals are held accountable for the external costs of their activities. An economic analysis of tort law focuses on issues such as the distinction between strict liability and negligence. The former suggests that people must be accountable for the injuries they cause, while the latter indicates that a person must be responsible for the harms resulting from their actions when they have failed to take the required precautions¹⁴. Initially, tort law applied in cases of accidents. However, with the development of the economy, the law has also been modified to ensure products and services are fit for consumption, eventually leading to the development of product liability law[15]. Today, there is strict liability for manufacturing and design defects. Business people are held accountable for not warning their consumers of possible defects in their products. Therefore, tort law shows some positive effects of the law on economics and vice versa. Without either, both manufacturers and consumers would suffer significantly.

Economics and Criminal Law

Only the state should enforce criminal law. Victims are not given the mandate to enforce criminal law to ensure that only a manageable number of criminals are caught. Enforcement resources are conserved. Consequently, the punishment of arrested criminals is multiplied to show a low probability of conviction and detection. However, the state uses other forms of punishment such as incarceration, because most of the caught criminals cannot meet the multiple fines. According to Woessmann, law, and economics imply that fines should apply when the convicted person can pay[16]. Fines are preferred in economics because they do not have a deadweight loss. Imprisonment is discouraged because it creates deadweight loss. That is, when a criminal is imprisoned, they cannot earn in the prisons legitimately¹⁶. The other form of deadweight loss that results from imprisonment is the cost of maintaining the prisoner in the penitentiary¹⁶. For example, taxpayers must provide guards and resources for building the prison. Economic theory also posits that that criminal, just like any other person, is motivated to act when there are incentives¹⁶. Therefore, there tend to be reduced levels of crime when the severity of punishment is high. Research has also shown this to be true in cases where murders are deterred when there is an execution of a criminal. In essence, when economics and criminal law work interchangeably, deadweight loss is avoided.

Conclusion

In conclusion, the essay has shown that law and economics have some connections, contributing to negative and positive effects in a business environment. The essay has been demonstrated that activity plays a critical role in foreseeing exchanges in the market. Contract law has been established for the sole purpose of ensuring that the contracting parties are held accountable for failure to abide by the agreed terms and conditions. Lastly, the essay has explained how tort law is being used today to ensure that manufacturers are held accountable for failure to warn consumers of possible defects.

Part 2

Question 1 – Money Supply

Money supply relates to the policies taken by the central bank to regulate the supply of money in the economy. Money supply can have adverse effects in several sectors of the economy, including unemployment, inflation, relative prices of goods and value of the local currency against other major currencies[17]. The monetary policy is essential for three main reasons:

• To maintain gross domestic product (GDP) stability,
• To maintain a low unemployment rate and,
• To keep the exchange stability.

Accordingly, the central bank uses several measures to maintain the money supply in the economy. These measures are discussed in the subsequent parts of the paper

Open Market operation (OMO)

The federal government employs OMO as a strategy of regulating money supply in the economy. Through the purchase of treasury bills and bonds in the open market by the Federal Reserve, there is an increase in money supply thus stimulating cash rotations. The reason is that customers are paid in cash and cash equivalent, thus facilitating the injection of money resources in the economy besides strengthening the lending capability of commercial banks. Conversely, the strategy can be used to reduce or mop up excess money in the market or among the public through the sale of bonds and other security bills to the public, who buy them using the excess money they have as an investment for future expenditure or income sources[18]. In this case, liquidity is reduced from the market to a sustainable economic level enough to curb inflation.

Quantitative Easing

The OMO monetary policy strategy can only be effective if the interest rates in the economy are nominal. However, when the interest rate is at zero or approaching zero, the OMO strategy cannot be effective; hence the central bank employs quantitative easing to stimulate economic growth. Quantitative easing refers to the purchase of treasury bonds by the Federal Reserve. It is a common strategy that was used by the central banks, especially after the 2008 economic meltdown. By purchasing government bonds and securities, the central banks create more money supply to improve the liquidity of the commercial banks. Increased purchase of the treasury bonds by a country’s central banks stimulates the use of cash by the public, hence stimulating money supply in the economy.

During the year 2008 economic meltdown, the US Federal Reserve used the quantitative easing technique to stimulate economic recovery in the country. By buying one thousand, two hundred and fifty (1, 250) billion dollars mortgaged securities and another three hundred (300) billion long term securities, the federal bank managed to initiate economic recovery[19]. As a result, the increase of money supply in the economy enhanced the consumer’s purchasing power through stimulating economic investment and consumption thus boosting the gross domestic product (GDP).

Figure 1: Nominal interest rate versus money supply

Figure 1 above shows the nominal interest rate (ir) versus the quantity of money. MD refers to money demand, and MS is the money supply curve.  As shown in the graph, the government can influence the nominal interest by controlling the money supply in the economy. At a low interest rate, bank loans become more affordable than when the nominal interest rates are high. As such, the public can borrow and invest as well as spend for consumption; therefore, this stimulates over consumer spending hence accelerating economic growth. The resultant effect is summarized through the following equation;

Where GDP – gross domestic product

C – Consumption

I – investment

NX –net export

G – Government spending

Hence, an increase in either of the factors shown in the model has a positive impact on gross domestic product. When consumers have access to money resources, they can invest, increase their disposable income thus increasing their purchasing power and production thus effectively improve the growth of the economy.

Question 2: Interest Rate versus Gross Domestic Product (GDP)

Loanable Funds Theory

The loanable funds’ theory refers to the method of interest rate determination basing on the forces of demand and supply. In this theory, the demand and supply for the interest rate are determined just like in the demand and supply for goods. Thus, the prevailing interest rate and the resulting effective level of economic activity is ascertained through the interaction of the forces of demand and supply market.

Figure 2: effective interest versus prevailing economic growth

From the chart above, the effective interest rate and the equivalent prevailing economic growth are indicated by P.e and Q.e. At this point, the intersection of demand for loanable funds equals its supply. Thus the effective interest rate is determined by the intersection of supply and demand. According to Hammond etl.,[20] the demand curve for loanable funds can shift due to two factors, namely, prevailing economic conditions and expansion of the monetary policy. The tradeoff between current and future consumption plays a critical role in the loanable funds’ theory particularly because people are motivated to forego current consumption and save for the future. Hence, the prevailing interest rate should be high enough to make the decision logical. The loanable funds’ theory is a continuation of the classical theory of interest rate, which determined interest purely as a function of savings (I) and investments (I). According to loanable funds theory, the demand for interest contributes to GDP in three main aspects:

Investment

Investment refers to expenditure incurred in the purchase of capital goods, including inventories, capital assets, new capital goods, and infrastructural development. The prevailing price for acquiring investment depends on the current interest rate. With a high-interest rate, the cost of investments tends to increase since investors must increase their prices to cover interest expenditure. As an entrepreneur, one must compare the cost of investment with the expected return. Hence, with all factors held constant, the expected rate of return must be higher than the interest rate for any investment to make economic sense.

Conversely, the low-interest rate stimulates the growth in GDP by encouraging spending on investments. Hence, with a low interest rate, the demand for loanable funds and investment will be higher. Thus, to stimulate economic growth in an economy, the government can lower the interest rate to increase the demand for loanable funds.

Hoarding

Hoarding refers to the practice of keeping money in cash form for speculative purposes. With the low interest rate, the demand for money for hoarding decreases. Hoarding has an inverse relationship with growth in GDP.

Dissaving

Dissaving refers to the act of using savings for recurrent expenditure. Dissaving hurts GDP. Unlike saving which stimulates economic growth, dissaving represents leakage from the GDP; hence, it negatively impacts its overall growth.

Interest rate and GDP

National output or GDP is a function of consumption, savings, and investment, government spending and net exports as shown in equation two below;

Where;

C – Consumption

I – investment

G- Government spending

X – Exports

M – Imports

As explainable under the loanable funds’ theory, interest rate affects each of these components of GDP differently. With a high-interest rate, consumption is likely to reduce because the rate renders the purchasing power of the consumer to reduce, hence leading to reduced consumption.

Further, a high-interest rate leads to increased inflation levels. According to classical economic theory, the high inflation rate erodes the purchasing power of the consumer. Hence their disposable income is drastically reduced which limits their expenditure on commodities that are given a specified value of money. Like consumption, the high interest rate hurts investment. The same theory indicates that the rate of interest determines the relative price of investment assets, for example, investment in real estate. Thus, a high-interest rate discourages investment spending in two ways; one by eroding the consumer’s purchasing power and increasing the relative price of an investment portfolio.

Moreover, high-interest rate stimulates the growth of savings. The reason is that the return on savings increases as the interest rate increases, boosting savings in an economy. Hence, interest rate and savings can stimulate growth in GDP in the same direction. Equally, the effect of interest rate on net exports depends on the prevailing interest rate in partner countries. An increase in the interest rate renders the value of the local currency as compared to partner countries, and then local goods become more expensive in the international market. Appreciation of the local currency impacts the relative price of commodities in the external market. Hence, with all factors held constant, an increase in interest rate reduces the value of exports in the country. Thus, the overall impact of interest rate on GDP can be summed up with the function:

Thus, reducing the interest rate can stimulate GDP growth by increasing the specified components of GDP.

Exemptions to the Rule

The reduction of interest rates as a tool for economic growth can be applied in various scenarios. However, in some exceptional cases like the case of Japan, lowering interest rates can lead to a recession in the economy contrary to the expectation. The lending decision by commercial banks does not depend on the rate of interest alone but the perceived risk of the borrower. Thus, commercial banks determine the prevailing interest rate to use while lending out based on the perceived risk level of the borrower. The charged interest rate should compensate the bank for taking the risk. Hence, with a low interest rate, banking institutions limit their lending to SME (small and medium-sized enterprises) and but increase lending to the government through the purchase of government bonds and treasury bills. The net effect on the economy is reduced borrowing, reduced spending, and negative GDP growth. Thus, in some cases, lowering the interest rate might not be the best policy if the intention is to stimulate GDP growth.

Questions 3

Ronald Coase (2012) developed the Coase theorem to address the issue of property rights between entrepreneurs and management[21]. Property is theoretical and legal ownership of property and how they can be applied. According to Ronald Coase, the point of conflict occurs when ensuring the optimal allocation of resources. Achlian Armed Indicates that the conflict between people in control of businesses and the real owners occurs due to different conflicting interests among the two. Hence, while the owners view their business as a long-life dream, the people in control view the company as a profit-making enterprise and therefore seek to make decisions that lead to the optimal allocation of resources. The Coase theorem strives to resolve the conflict between the parties by attempting to clarify that for an efficient market with no transaction cost, an efficient set of inputs should be selected to transform the inputs to optimal output. The decision regarding resource allocation in a firm should be based purely on optimizing production regardless of the personal views of the owners or management[22]. Thus, according to the Coase theorem, a firm should arrive at the same decision regarding optimal utilization of output regardless of its control. In case of a conflict between the parties, it should be settled in a way that ensures optimal resource utilization.

More so, the Coase theorem tries to resolve the conflict of control and ownership of the business. Every entrepreneur starts a business to succeed and inspire a generation. However, as the business grows, the founders are forced to exit the top management as the board deems them unfit to steer the company in the right direction. Steve Jobs is a prominent example of entrepreneurs who were forced to resign from the CEO position by the board. According to classical economics, by striving to control the firm while ensuring optimal allocation of resources is a tradeoff for many founders. In his analysis, the founders are left with two choices, to create wealth or gain control and in most cases, the choice of one means losing the other. In short, it is difficult for an entrepreneur to gain wealth while ensuring full control of the business. The assumptions of Coase theorem include;

• The property rights must be fully defined
• There should be minimum or no transaction cost
• The parties affected should be few to keep the transaction cost minimum. An increasing number of parties imply an increase in transaction costs.
• There should be no wealth effects, implying that the optimal decision, regardless of the party controlling the business, will remain the same.

 Thus, the business owners and those controlling the business should make the same decision regarding optimal resource allocation.

Business Application of Coase Theorem

Ronald Coase used several examples of optimal resource allocation to explain the Coase theorem. For instance, a firm can produce noise in the cause of production. Since noise is a source of nuisance to the surrounding community, the firm has two options to deal with this;

Option 1

The firm can pay the surrounding neighbors to compensate them for noise pollution. However, before making this decision, the firm should ascertain that the cost of paying the neighbors is lower than the value obtained by manufacturing the product. Thus, if by paying the neighbors and continue to produce the product that leads to noise pollution, the firm maintains high profits, then that is the optimal decision.

Option 2

The neighboring community can decide to pay the firm and compel it to stop producing the product leading to noise pollution. The optimal decision for the firm is determined by the value of compensation and the cost foregone. If the firm will make high profits by producing what the community is willing to offer, then the optimal decision is to continue providing the commodity. The above scenario can be explained by the chart below;

Note: C & B – cost and benefits

Figure 3: Cost and benefit versus the units of effluent permitted by a company.

Figure 3 above is an exhibition of the relationship between costs and benefits versus the effluent produced as permitted for the company or acceptable by the affected community. Thus, the optimal decision for the firm is at the point where the benefits to the firm are equal to the cost to the community. Any point outside the optimal point is a cost to the firm or a missed opportunity. Coase theorem speculates that the optimal decision should be the same regardless of the decision-maker[23]. Hence, whether the owner or an employed manager controls the firm, the optimal choice should remain the same.

Coase Theorem Criticism

In the real world, the application of the Coase theorem is limited by its assumptions. The assumption of perfect flow of information, zero transaction cost and adequately defined property rights are unreal. In the real world, the optimal decision can be hard or impossible to obtain due to the limitations of the Coase theorem assumptions. Further, the interference of outside parties like the government policy makes the optimal decision impossible to attain. For instance, in the case of the above firm, the government can legislate a policy against environmental pollution, hence making it illegal for the firm to produce if the production leads to noise pollution.

Case of Russia

The disintegration of the Soviet is a classic example of conflicting property rights. Since its formation, the main aim of the union was to foster trade relations and economic empowerment of member countries. In its active years, member countries enjoyed economic prosperity as a result of several economic policies of the union like free movement of goods, limited barriers to trade, access to global markets among others[24]. Easing of the government power by the then president of the Soviet Union ignited a series of events that led to a fall of the union in 1989. When Mikhail took over the control of the union in 1985, his main agenda was to foster economic growth in the union. To achieve this, he had to dismantle the secret policies and introduce several economic restructuring policies referred to as perestroika. Unfortunately, most member states in Eastern Europe were not impressed by his strategy. While Mikhail pushed for economic prosperity, member states pushed for democratic expansion and independence. Hence, these conflicting interests led to the coup attempt in 1989, igniting a series of events that led to the collapse of the union in 1989.

Question 4: Tort Law – Property Protection

Tort law refers to a civil wrong that results in the suffering of a loss or being harmed[25]. In this case, the legal liability is attributed to an individual that causes suffering or harm. The harm varies from negligence, intentionally inflicting emotional distress, injuries, and financial loss, among other damages. In this case, when one falls on a slippery ground and is injured, emotionally embarrassed, or affected in any way in a public place, the responsibility is not attributed to anyone but the government. The government is responsible for ensuring that its citizens are safe, including the security of where they walk, sleep and work from; hence, such a case is related to the law of tort.

Question 5: The Setting of International Exchange Rates

According to Milton Friedman,[26] the international exchange rate relates to the value of one currency in terms of another currency. For instance, an American might be interested in investing in Europe. The relative cost of the investments should be determined in terms of dollars; hence the exchange rate between the dollar and the Euro is significant to such investor for various reasons, which include;

• It ensures the international balance of payments
• It is critical in stabilizing the currency exchange rate
• It determines the control inflation in an economy
• Helps foster international transactions like a Chinese company purchasing stock in an American company
• Can help prevent speculative capital in large scale
• It serves to increase foreign assets

The international exchange rate can be floating or pegged, as discussed in the following sections.

Floating Exchange Rate

In a floating exchange regime, the exchange rate is allowed to fluctuate in response to the exchange market news. If the demand for a currency is high, its value in the international markets tend to increase, and if the demand for the currency is low, its value in the international markets tend to decline. For instance, the announcement of Brexit saw the pound reach an all-time low exchange rate in the history of British sterling. Most foreign exchange currencies, including the U.S. Dollar, Indian Rupee, Japanese Yen, Sterling Pound and Euro, use a floating exchange regime in the international exchange rate. The Canadian dollar is the best example of a floating rate since the Canadian government does little to interfere with its value in the international market. Historically, the economic powerhouse of the world including the G7 economies, operated on a fixed exchange regime. For instance, the US fixed the value of the dollar at 1/35^th ounce of gold. This exchange rate was in use since the launch by the Britton Woods system in the early 1970s. However, as the gold reserves and gold deposits in the international market declined, the US found it impossible to peg the dollar against gold, hence abandoned the fixed regime for the floating system in the 1980s.

Economic Rationale of the Floating Regime. The floating exchange regime is desirable to an economy for various reasons. In case of an economic shock, the floating exchange regime can adjust automatically, hence absorbing the external shocks in the economy.

Further, the floating exchange regime is desirable in enhancing g the balance of payments in the international market. Since the exchange rate is determined merely by the demand and supply of a currency, it becomes easy to attain the balance of payments. However, the floating exchange rate has some adverse effects on the economy. For instance, it is a cause of economic imbalance and instability. Hence, it becomes hard for businesses to make plans and prepare budgets adequately when the economy is unstable and characterized by uncertainty.

Fixed Exchange Rate

The fixed exchange rate is also known as the pegged exchange rate. It refers to the exchange rate that is set by the central bank of a country.  According to Levy Yeyati (2005), the main reason for controlling the exchange rate is to maintain economic stability and reduce uncertainties. Preserving and sustaining the exchange rate is enhanced by controlling the purchase and sale of the currency of the desired country. While the pegged exchange rate has some desirable benefits in the economy, like creating stability and certainty, equally, it can lead to some adverse effects as well. For instance, the Asian crisis that rocked the countries of South East Asia in the year 1997 was mainly caused by the consequences of a fixed exchange regime. Some of the economies that were affected include Singapore, Indonesia, Malaysia, and the Philippines. To attract foreign investors in the region, the government pursued a fixed exchange rate to maintain the substantial value of the currency. As a result, this led to the rising cost of investments, government spending, borrowing, and rising real estate costs. Thereby, an economic bubble emerged after most companies realized that the increasing cost of assets was unsustainable prompting investors to peg the local currency in terms of the dollar.

Factors Influencing the Exchange Rate.

In a floating exchange rate, the value of the currency is determined purely by the forces of demand and supply[27]. For instance, if the demand for the dollar is high in the international market, then this stimulates the supply for the dollar leading to its appreciation. The forces of demand and supply in the foreign exchange market responds mainly to the political and economic announcements made by the specific country. Some of the prominent announcement which affects the value of the currency include interest rate, GDP, inflation and the level of unemployment in an economy. Thus, the changes in these components affect the performance of the exchange regime either favorably or otherwise, with impacts felt in the economic performance.

Further, speculation, disaster, and rumors can cause short term movement of the currency. Owing to these events, the currency demand might increase or decrease based on the nature of the announcement. Such events and announcements can be beneficial to forex traders who rely on short term movement of the currency to earn a profit. However, the foreign exchange rate can be stimulated to increase or decrease by the investors by manipulating the information to get the desired movement. When this happens, the central bank is forced to step in and regulate the currency movement to prevent excessive depreciation or appreciation of the currency. Also, macro factors such as growth in gross domestic product, inflation, political influence, among others, affect the price of exchange rate prices. The China – U.S. trade wars is a classic example of the interplay of the macroeconomic factors. Since ascending to power, President Trump has intensified the need to advocate for tariffs to reduce the trade deficit between China and the US which is at an all-time high. The trade war that has begun in 1980, therefore, has reached a full-blown level during the Trump administration, even affecting private companies like Huawei Corporation, a China-based company.

Huawei is a leading telecommunication company from China. The company has had to face trade sanctions from leading economic giants, including the US, the UK, and Canada, among others. Huawei was accused of a conspiracy to defraud international companies by practicing unfair trade strategies. To continue operating in the international markets, Huawei ignored trade sanctions from most countries including Iraq and misrepresented its financial information by reporting its subsidiaries as separate entities[28]. This fueled a series of trade suctions leading to a full-blown withdrawal of Huawei phones from leading international markets, including the US, in 2018. In response to Huawei sanctions, the Chinese government took the following measures;

Increasing Import Tariffs on US-Based Products

The net impact of this move was an increase in the price of US products in the local China market, making them undesirable.

Depreciating the Yen

The depreciation of the local currency makes the prices for its exports cheaper in the international market. Hence, by devaluing the local currency, the Chinese government made Chinese products more affordable compared to US-based products.

The US-China trade war has intensified thereby attracting the attention of the federal government. According to the trade war, Act of 1974 was legislated to prevent the instances of the trade war between the US and other leading trade partners[29]. Some of the recommendations of the trade act which should be pursued include:

• Using the international community like the World trade organization to resolve the conflict.
• Imposing trade sanction s on foreign goods if the importation of such goods threatens the local manufacturing.
• Increasing import duty on foreign products. This way, the foreign goods will be more expensive in the local US market hence reducing their demand.
• Increase and widen the market for US products in the international market. To achieve this, the federal governments should pursue intensive trade partnerships and agreements with partner countries to obtain favorable tariffs.

Thus, these macroeconomic factors have an impact on the foreign exchange rate. While imposing tariffs barriers or negotiation tariffs, the government influences the foreign exchange rate directly.

Question 6: Why Fixed Exchange Rate Does Not Work?

The fixed exchange rate refers to an exchange rate system whereby the value of the currency is pegged against the other. In a fixed exchange rate, the central bank has a predetermined rate and pursues measures to keep the rate constant.The origin of the fixed exchange rate system was from the Britton Woods Conference of 1944[30]. During the conference, which was attended by 44 countries, including the US, it was concluded that the dollar exchange rate should be pegged on gold while other currencies are pegged on the dollar. For a while, the Briton wood was effective in ensuring economic stability and prosperity of the member states. However, economic occurrences including the outbreak of the two world wars, changed the economic dynamics of the countries, hence making Britton Woods ineffective in exchange rate determination.

The collapse of the Britons System

After the enactment of the system, it became apparent that the US dollar was overvalued. Further, rapid government spending initiated by the onset of the Vietnam War in 1968 deteriorated the value of the dollar. With the start of the Vietnam War and the juts ended world war, gold deposits in the global market begun declining, hence limiting the application of the fixed exchange rate system.

Moreover, the need for economic stimulation and the need for providing aid to developing countries necessitated the need to abandon a fixed regime. At the end of 1961, US President Richard Nixon announced the end of the fixed regime by giving a suspension to the regime[31]. This action led to the birth of a floating exchange, which was adopted as the official exchange regime three years later in 1963. For the first time in history, the value of the dollar was seen to appreciate from 35 dollars per ounce of gold to 38 dollars per ounce of gold.

Limitations of the Fixed Exchange Rate

The fixed exchange rate has some desirable outcomes in the economy. Some results, like economic stability, can lead to economic prosperity. However, in some cases like in Switzerland, the pegged regime can lead to economic impairment as explained in the following parts.

Loss of control over the monetary policy. The major limitation of the fixed exchange regime is the loss of control over the exchange regime. In a floating regime, countries can take appropriate measures to correct the adverse economic effects in the economy. For instance, in the event of an unfavorable balance of payments, the countries can devalue their currency to stimulate exports in the economy. With a fixed exchange regime, this option is unavailable to countries; hence in the event of economic shock, the country must suffer the consequences fully.

It makes the economy vulnerable to speculators. In a fixed exchange regime, the speculators can hoard foreign currency in the short run to cause a devaluation of the currency. In 1992, Gorge Soros single-handedly influenced the value of the pound until the UK central bank had to adapt to a flexible regime. Switzerland is another example of an economy adversely affected by speculating investors. In 2015, Swiss France kept depreciating until the Switzerland central bank was forced to adopt a flexible regime.

Expensive to maintain. The other reason that makes a fixed exchange rate fail to work is that it is impossible to maintain. The fixed exchange rate requires a massive supply of foreign reserves to ensure that the country has enough to balance any shift from the desired exchange rate[32]. Fiji and Kuwait are some examples of countries with a fixed exchange rate. While the economies of these countries are small, they manage to implement the fixed exchange rate by pegging their currency to the US dollar. The other two notable cases of economies where the fixed exchange rate failed to work due to large reserve requirements are China and Thailand. Some instances of failed fixed exchange rate regimes include;

China Reserves Crisis of 2012. China is an example of an economy with a failed fixed exchange rate. Before abandoning the fixed exchange rate in 2012, the Chinese government had to invest a massive amount of money in purchasing foreign currency. By 2011, Beijing had accumulated foreign currency above 2.8 trillion dollars[33]. The amount was the biggest in the entire Asia region, even more than Japan’s reserves. As the need to accumulate more foreign currency intensified, the Chinese government realized that the fixed regime was becoming unsustainable, hence abandoning the regime in 2012.

The Thai Experience. Since the Britton Wood system was launched in 1944, Thailand was one of the economies whose currency was pegged to the dollar. The 1997 adverse capital markets vents weakened the Bhat exposing the domestic economy. If Thailand were using a flexible exchange regime, the exchange rate would have adjusted automatically to cope with global events. However, since the currency exchange regime was fixed, there is nothing the government could do to correct the devaluation of the currency. The currency depreciation plunged the country into an economic crisis characterized by high inflation, shrinking economic output, and high unemployment rate. As a result, Thailand decided to abandon the fixed exchange and adopt a floating regime in 1998.

Bibliography

Aaken, Anne van. “Behavioral International Law and Economics.” Harvard International Law Journal 55, no. 2 (2014): 421-481.

Anderson, Terry L., and Fred S. McChesney. Property rights: cooperation, conflict, and law. Princeton, N.J: Princeton University Press, 2003.

Bag, Sugata. Economic Analysis of Contract Law: Incomplete Contracts and Asymmetric Information. Springer, 2018.

Carty, Hazel. An analysis of the economic torts. Oxford University Press, USA, 2010.

Chen-Wishart, Mindy. Contract law. Oxford University Press, 2012.

Coase, R. H. The firm, the market, and the law. Chicago: University of Chicago Press, 1988.

Coase, R. H., and Ning Wang. How China became capitalist. Houndmills, Basingstoke, Hampshire New York, NY: Palgrave Macmillan, 2012.

Coase, Ronald H. “Notes on the problem of social cost.” The Firm, the Market, and the Law 157 (2012).

Cooter, Robert, and Thomas Ulen. Law and Economics. Boston: Addison-Wesley, 2016.

Gibbons, Robert, and John Roberts. The Handbook of Organizational Economics. Princeton: Princeton University Press, 2013.

Hammond, Gill, Kanbur, and Eswar Prasad. Monetary policy frameworks for emerging markets. Cheltenham, UK Northampton, MA, USA: Edward Elgar, 2009.

Harper, Michael C., Samuel Estreicher, and Joan Flynn. Labor law: cases, materials, and problems. New York: Aspen Publishers, 2003.

Kaplowitz, Michael D. Property rights, economics, and the environment. Stamford, Conn: JAI Press, 2000.

Keynes, John M. The general theory of employment, interest, and money. Cham, Switzerland: Palgrave Macmillan, 2018.

Klein, Michael W., and Jay C. Shambaugh. Exchange rate regimes in the modern era. Cambridge, Mass. London: MIT Press, 2012.

Liviu, Neamţu, and Neamţu Adina Claudia. “The role of supply and demand analysis in substantiating the company’s business policies.” African Journal of Business Management 5, no. 22 (2011): 9180-9190.

MacDonald, Ronald. Exchange rate economics: theories and evidence. London New York: Routledge, 2007.

Nüesch, Sabina. Voluntary export restraints in WTO and EU law: consumers, trade regulation, and competition policy. Bern New York: Peter Lang, 2010.

Pal, Malabika. Economic Analysis of Tort Law: The Negligence Determination. Routledge India, 2019.

Schroeder, Jeanne L. The triumph of Venus: the erotics of the market. Berkeley: University of California Press, 2004.

Woessmann, Ludger. “Efficiency and equity of European education and training policies.” International Tax and Public Finance 15, no. 2 (2008): 199-230.

Zamir, Eyal, and Doron Teichman. Behavioral law and economics. New York, NY: Oxford University Press, 2018.

Zamir, Eyal, and Doron Teichman. Behavioral law and economics. Oxford University Press, 2018.

---

[1]Cooter, Robert, and Thomas Ulen. Law and Economics. Boston: Addison-Wesley, 2016.

[2]Aaken, Anne van. “Behavioral International Law and Economics.” Harvard International Law Journal 55, no. 2 (2014): 421-481.

[3]Gibbons, Robert, and John Roberts. The Handbook of Organizational Economics. Princeton: Princeton University Press, 2013.

[4], Liviu, Neamţu, and Neamţu Adina Claudia. “The role of supply and demand analysis in substantiating the company’s business policies.” African Journal of Business Management 5, no. 22 (2011): 9180-9190.

[5]Liviu, Neamţu, and Neamţu Adina Claudia. “The role of supply and demand analysis in substantiating the company’s business policies.” African Journal of Business Management 5, no. 22 (2011): 9180-9190.

[6]Cooter, Robert, and Thomas Ulen. Law and Economics. Boston: Addison-Wesley, 2016.

[7]Cooter, Robert, and Thomas Ulen. Law and Economics. Boston: Addison-Wesley, 2016.

[8]Coase, Ronald H. “Notes on the problem of social cost.” The Firm, the Market, and the Law 157 (2012).

[9]Zamir, Eyal, and Doron Teichman. Behavioral law and economics. Oxford University Press, 2018.

[10]Bag, Sugata. Economic Analysis of Contract Law: Incomplete Contracts and Asymmetric Information. Springer, 2018.

[11]Bag, Sugata. Economic Analysis of Contract Law: Incomplete Contracts and Asymmetric Information. Springer, 2018.

[12]Chen-Wishart, Mindy. Contract law. Oxford University Press, 2012.

[13]Chen-Wishart, Mindy. Contract law. Oxford University Press, 2012.

[14]Carty, Hazel. An analysis of the economic torts. Oxford University Press, USA, 2010.

[15]Pal, Malabika. Economic Analysis of Tort Law: The Negligence Determination. Routledge India, 2019.

[16]Woessmann, Ludger. “Efficiency and equity of European education and training policies.” International Tax and Public Finance 15, no. 2 (2008): 199-230.

[17]Schroeder, Jeanne L. The triumph of Venus: the erotics of the market. Berkeley: University of California Press, 2004.

[18]Kaplowitz, Michael D. Property rights, economics, and the environment. Stamford, Conn: JAI Press, 2000

[19]Hammond, Gill, Kanbur, and Eswar Prasad. Monetary policy frameworks for emerging markets. Cheltenham, UK Northampton, MA, USA: Edward Elgar, 2009.

[20]Hammond, Gill, Kanbur, and Eswar Prasad. Monetary policy frameworks for emerging markets. Cheltenham, UK Northampton, MA, USA: Edward Elgar, 2009.

[21]Coase, R. H. The firm, the market, and the law. Chicago: University of Chicago Press, 1988.

[22]Coase, R. H., and Ning Wang. How China became capitalist. Houndmills, Basingstoke, Hampshire New York, NY: Palgrave Macmillan, 2012.

[23]Coase, R. H., and Ning Wang. How China became capitalist. Houndmills, Basingstoke, Hampshire New York, NY: Palgrave Macmillan, 2012.

[24]Kaplowitz, Michael D. Property rights, economics, and the environment. Stamford, Conn: JAI Press, 2000

[25]Anderson, Terry L., and Fred S. McChesney. Property rights: cooperation, conflict, and law. Princeton, N.J: Princeton University Press, 2003.

[26]Kaplowitz, Michael D. Property rights, economics, and the environment. Stamford, Conn: JAI Press, 2000

[27]Klein, Michael W., and Jay C. Shambaugh. Exchange rate regimes in the modern era. Cambridge, Mass. London: MIT Press, 2012.

[28]Schroeder, Jeanne L. The triumph of Venus: the erotic’s of the market. Berkeley: University of California Press, 2004.

[29]MacDonald, Ronald. Exchange rate economics: theories and evidence. London New York: Routledge, 2007.

[30]Nüesch, Sabina. Voluntary export restraints in WTO and EU law: consumers, trade regulation and competition policy. Bern New York: Peter Lang, 2010.

[31]MacDonald, Ronald. Exchange rate economics: theories and evidence. London New York: Routledge, 2007.

[32]Keynes, John M. The general theory of employment, interest, and money. Cham, Switzerland: Palgrave Macmillan, 2018.

[33]Coase, R. H., and Ning Wang. How China became capitalist. Houndmills, Basingstoke, Hampshire New York, NY: Palgrave Macmillan, 2012