In historical times, when metals such as gold or silver were used as money, tight money resulted from the actual quantity of the metal available. However, in modern times, tight money results from monetary policy by the central banking authority. In the United States, the Federal Reserve System can pursue of a course of tight money through contractionary monetary policy.

A Blast From The Past

For example, when beaver pelts were used as money in the colonial days of North America, a depletion of the beaver population led to a scarcity of beaver pelts and tight money. When gold was used as money in the United States during the 1800s, the exhaustion of a major deposit often led to a drop in the available quantity and tight money.

Modern Manipulation

Modern monetary policy makes use of three tools--open market operations, the discount rate, and reserve requirements. Contractionary monetary policy and tight money arises when the Fed uses these tools to decrease the quantity of money available.

• Open Market Operations: This occurs when the Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of excess reserves that banks have available to make loans and to create money and is the primary monetary policy tool used by the Fed. Contractionary monetary policy and tight money result if the Fed sells Treasury securities. This means banks have fewer reserves that they can then use to make fewer loans at higher interest rates, which decreases the money supply.


• Discount Rate: This is the interest rate that the Fed charges banks for borrowing reserves. Higher or lower rates affect the amount of excess reserves that banks have available to make loans and create money. Contractionary monetary policy and tight money result if the Fed raises the discount rate. In this case, banks can borrow fewer reserves, which restricts their ability to make more loans which they do at higher interest rates. The result is a decrease in the money supply. Changes in the discount rate are most often used as a signal for monetary policy actions.


• Reserve Requirements: These are the rules established by the Fed to regulate the amount of reserves that banks must keep to back outstanding deposits. Higher and lower reserve requirements affect the amount of deposits banks can create with a given amount of reserves. Contractionary monetary policy and tight money result if the Fed raises reserve requirements. With this change banks can use existing reserves to make fewer loans and thus decrease the money supply. This tool is seldom used as a means of controlling the money supply.

The Good, The Bad

• The Good: On the positive side, tight money induces lower prices and inflation. While this might be bad for sellers, it is good for buyers. The value of the monetary unit increases as fewer monetary units circulate through the economy. This is particularly good for people who own a lot of monetary units. In particular, anyone with a great deal of financial assets are helped by tight money. This includes those on the lending side of a financial transaction. The payment received on a debt is worth more than the amount originally loaned.


• The Bad: On the negative side, tight money restrains the economy. People are able to purchase fewer goods and services, which decreases production and employment, and increases the unemployment rate. Fewer workers have jobs and those jobs pay lower wages. The economy is likely to be contracting. With limited access to money, anyone in debt will find it harder to pay off loans.

• The Winners: Those helped by tight money tend to be on the higher end of the income spectrum, with a great deal of financial wealth. With money less abundant, what they have is worth more. To the extent that they are also on the employer side of the labor market, then they have pay lower wages for labor. To the extent that they are net lenders, then loan repayments are worth more as well. Historically, political conservatives and Republicans have counted these sorts of folks among their constituency and thus tend to favor tight money when in power.


• The Losers: Those hurt by tight money are usually working class folks, with very little financial savings and a significant amount of financial debt. They are likely to suffer from a contracting economy, higher unemployment, and lower wages. They have little financial wealth that might be helped by lower inflation, and they find it harder to pay off outstanding debt. Historically, political liberals and Democrats have counted these sorts of folks among their constituency and thus tend to oppose tight money when in power.

The Easy Money Alternative