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Economics 101

Economics is one of the more difficult subjects that extemp covers. In this article, Ananth Veluvali breaks down interest rates and modern monetary theory.

Topic #1: The Federal Funds Rate (Interest Rates)

During the Great Depression, many Americans attempted to withdraw their money from the bank. Unfortunately, banks were overwhelmed with withdrawal requests and didn’t have enough money to fulfill people’s demands. The result? Millions of people lost their life savings and were left in the dust.

In response, the government created reserve requirements, which mandated that banks keep a certain percentage of their deposits on hand as cash. This helps ensure that banks have enough money to fulfill Americans’ withdrawal requests. Before the pandemic, the reserve requirement was 10%, although that number currently stands at 0%.

So, how do interest rates fit into all of this?

When banks are approaching the reserve requirement and are strapped for cash, they can borrow money from other banks (Goldman Sachs can lend money to Bank of America, for example). The suggested rate at which banks lend and borrow loans to each other over night is called the Federal Funds Rate. When people talk about the Federal Reserve raising interest rates, that’s typically what they are referring to.

Keep in mind that since this is a suggested rate, banks could hypothetically choose to ignore the Fed’s target rate. More often than not, though, they use the Fed’s rate as a guidepost. The Fed meets eight times a year to discuss the Federal Funds Rate.

Now this all brings up another question: why do interest rates matter?

Remember your elementary school & middle school math problems about interest? In the real world, interest works in a similar way. Put simply, interest is the rate at which a borrowing bank pays back a loan to a lending bank. A bank that took out a $1 billion loan at 5% interest would pay $1.05 billion, for example. Meanwhile, a bank that took out a $1 billion loan at 30% interest would pay $1.30 billion.

This is important to remember: the higher the interest rate, the more expensive it is to pay back a loan. That’s why the Federal Reserve focuses on cutting interest rates during economically turbulent times — doing so makes it cheaper for banks to borrow and lend money. If banks can more easily access cash, they’ll be more inclined to give out loans to American consumers. In turn, when rates are low, it’s easier for Americans to take out a loan & use that loan to take out a mortgage, purchase a car, or start a new business. That type of consumption fuels the economy.

Topic #2: Modern Monetary Theory (MMT)

Modern Monetary Theory was once a seldom discussed idea in academic circles. However, as individuals ranging from Alexandria Ocasio-Cortez to Wall Street economists have embraced the theory, economists are giving it a second look.

At the core of the MMT argument is the assertion that countries—like the United States—which issue & control the money they use for taxing and spending never have to default (a word used when an entity fails to pay back a loan). Indeed, even if the US ran out of money to pay creditors with, it could print more.

Under this view, taxation isn’t the tool governments use to pay for spending. Instead, the government prints money whenever it wants to spend.

So what role, if any, does taxation play in a MMT environment? According to MMT proponents, there are two primary functions. Firstly, taxation tethers Americans to the US dollar. Since Americans have to pay their taxes with the dollar, they are more likely to earn & use the dollar than another currency (like the yen). Secondly, taxation controls inflation. Every single dollar the government taxes is a dollar that is taken out of the economy, which prevents prices from exploding.

In fact, some MMT economists go on to view the economy through a “sectoral balances” framework. This framework implies that when the government has a deficit, some other area—either the global economy or the domestic economy—has a surplus (after all, in their mind, who else would the government have a deficit to?). Alternately, when the government is running a surplus, it usually means the private sector is running a deficit.

As an article by Vox puts it, “Indeed, in their textbook Mitchell, Wray, and Watts suggest that the 2001 recession was the result of the US fiscal surplus at that time forcing the private sector into deficit: “In most advanced economies, sharp, severe economic downturns typically follow a period when fiscal surpluses are accompanied by large private sector deficits.”

“In the long term,” they conclude, “the only sustainable position is for the private domestic sector to be in surplus.” As long as the US runs a current account deficit with other countries, that means the government budget has to be in deficit. It isn’t “crowding out” investment in the private sector, but enabling it.”

Now with an MMT government adopting policies that are continually in flux, job certainty in the private sector would decrease (something even MMT proponents concede). However, the final plank of many MMT proponents plan is a universal jobs guarantee. Any downtrodden American looking for a stable source of income would be provided one by the US government. This promise has drawn waves of criticism from MMT opponents.

So that’s MMT described (as neutrally as possible) in a nutshell. Hopefully you have the understanding to form an opinion now!

Conclusion:

Economics is a confusing subject, and you likely won’t have the time to explain concepts like MMT or interest rates as thoroughly as this article. Still, hopefully this article provided you with the understanding to comfortably approach economics topics with ease. Best of luck!

By Ananth Veluvali

Founder, the Extemper's Bible.

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