What makes monetary policy ?loose? or ?tight??

April 2nd, 2007

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Often, we hear of the adjectives ?tight? or ?loose? with regards to monetary policy of the central bank. What is the meaning of these adjectives?

First, let us define what is monetary policy. According to a textbook definition, ?monetary policy? is defined as:

The pursuit of desired outcomes with respect to quantity of money and credit and the cost of funds (that is, the rate of interest).

Thus, the central bank uses monetary policy to control the quantity of money and credit in the economy so as to achieve certain economic conditions (e.g. lower price inflation). Monetary policy is considered ?tight? if it reduces the quantity of money and credit. Conversely, it is considered ?loose? if it the quantity is increased.

One of the tools the central bank for its monetary policy is the setting of interest rates. In many countries (including the US and Australia), the central bank does not set the quantity of money and credit as a policy objective. Instead, it injects (or drains out) whatever amount of money into the economy so as to enable interest rates to arrive at the level that it wants. For example, if the Fed decides to set interest rates to x%, it will then pump in (or draw out) money into the financial system so that the cost of money will be priced at x%.

A common misperception is to assume that any rise in interest rates automatically implies a monetary tightening (and conversely for a fall in interest rates). For example, when Japan was hit by a severe recession in the 1990s, even the slashing of interest rates to a zero was still considered ?tight.? In Zimbabwe today, in such a hyperinflationary environment, even raising interest rates to 600% is still considered ?loose.? Why is this so?

To understand why, we have to remember that the central bank cannot control the demand for money and credit. It can supply whatever amount of them that it wants, but it cannot force business and people to desire them. Put it simply, you can lead a horse to the water, but you cannot force it to drink. For example, if the economy is hit with such a severe recession that the demand for money and credit collapses completely, even cutting interest rates to zero may not be enough to tempt people and business to demand more of them. Consequently, the central bank will have to mop up the excess money in the financial system, which will result in a reduction in the money supply. When that happens, monetary policy is still ?tight.?

In short, the level of interest rates will not tell you whether money is ?tight? or ?loose.? The only way to find out is to check out the rate of growth (or contraction) of money.