The Effects of Tightening Monetary Policy

Monetary policy is the management or political maneuvering of the nation’s economy. In the United States, the Federal Reserve is responsible for making monetary policy. The Federal Reserve typically sets the discount and prime interest rates for lending money in the open market. The discount rate is the interest rate banks charge among themselves when lending to each other. The prime rate is the base interest rate charged to consumers for borrowing money. Increasing these interest rates is “tightening” the economy, with several intended effects in personal and business environments.

Manage Growth

The Federal Reserve uses tight monetary policies to manage overall economic growth in the United States. Gross domestic product (GDP) is the most common indicator of economic growth in the United States. GDP represents the total of all goods produced inside the country. Russell Kirk, author of “Economics: Work and Prosperity,” writes that extremely high growth rates--such as 7 percent or higher–are typically viewed as unsustainable. Raising the discount and prime interest rates creates a tight economic environment where the supply of money decreases. Decreases in the supply of money eventually result in a decrease in GDP, creating a more sustainable economic environment.


Inflation is a primary concern for the Federal Reserve. The classic definition of inflation is too many dollars chasing too few goods. High inflation increases the price wholesalers and businesses ask for economic resources. While inflation is a natural consequence of economic growth, loose monetary policies can artificially increase inflation. Loose monetary policies result from low discount and prime interest rates. The Federal Reserve uses tight monetary policies to reduce the effects of inflation and tighten the economic market. Severe tightening of the economic market can result in deflation. Deflation occurs when consumers do not have enough money to purchase economic resources, which lowers prices and may result in extreme layoffs or bankruptcies from the lack of business profit.


Credit represents the loans banks make to individuals and their businesses. Tight monetary policies can reduce the amount of credit, because banks do not generate enough income from the interest rates on loans. The interest rate on loans is directly affected by the prime rate set by the Federal Reserve. Individuals and businesses with insufficient capital balances may also be unable to repay personal or business loans. Banks are usually unwilling to loan money when individuals or businesses cannot repay the balance.