That part of the government's economic policy which tries to control the size of the total stock of money (and other highly liquid financial assets that are close substitutes for money) available in the national economy in order to achieve policy objectives that are often partly contradictory: controlling the rate of increase in the general price level ( inflation ), speeding up or slowing the overall rate of economic growth (mainly by affecting the interest rates that constitute such a large share of suppliers' costs for new investment but partly by influencing consumer demand through the availability of consumer credit and mortgage money), managing the level of unemployment (stimulating or retarding total demand for goods and services by manipulating the amount of money in the hands of consumers and investors), or influencing the exchange rates at which the national currency trades for other foreign currencies (mainly by pushing domestic interest rates above or below foreign interest rates in order to attract or discourage foreign savings from entering or leaving domestic financial markets). Monetary policy is said to be "easy," "loose," or "expansionary" when the quantity of money in circulation is being rapidly increased and short-term interest rates are thus being pushed down. Monetary policy is said to be "tight" or "contractionary" when the quantity of money available is being reduced (or else allowed to grow only at a slower rate than in the recent past) and short-term interest rates are thus being pushed to higher levels.
The government's ability to control the size of the money stock and the levels of interest rates is only partial, not absolute. This is because monetary policy makers must rely mainly on influencing the privately-owned banking system's supply schedule for loaned funds. Monetary policy makers are much less able to affect the private sector's demand schedule for such funds, yet both supply and demand for money interact to determine the quantity of money created and its price, the interest rate. Even in trying to control the supply side of the loan market, it is easier for the Fed to force the banks to tighten credit and make fewer new loans (by raising the legal reserve requirements, for example) than it is to convince them to extend a larger volume of loans when bankers have become worried about their prospects for being repaid (or fear rapid inflation will cause their repayments to be worth less than the original value of the their loans). Government monetary policy-makers are generally much more successful in manipulating short-term interest rates (rates on loans for periods of less than a year) than they are in manipulating medium-term interest rates (1 to 5 years) and long-term interest rates (more than five years). This is because demand and supply for medium-term and long-term loans tend to be both much more elastic and much more affected by the public's expectations about future rates of inflation than the supply and demand for short-term loans are. A very expansionary monetary policy may well lower short-term interest rates by flooding the banks and financial markets with loanable funds and yet at the same time may actually raise longer-term interest rates by prompting fears among lenders that inflation will soon be accelerating. More ...