When money is tight, interest rates on commercial loans, mortgages, credit cards, etc. go up. These hikes are engineered by a central bank, such as the Federal Reserve in the U.S. or the Bank of England in Great Britain, to curb inflation.
Inflation flares up whenever too much money chases too few goods. Everything becomes more expensive as the real value, or purchasing power, of a dollar or euro or yen declines. Left unchecked, hyperinflation sets in and a paper currency can become virtually worthless. To prevent this, central banks "pull the string" by reducing the amount of money in circulation, and everyone tightens their belts.
For centuries, the amount of gold or silver that a nation held to back its currency determined its value. The amount of money in circulation literally depended on how much of these precious metals miners extracted each year. As populations grew, the 'tighter' currencies backed by precious metals became. Today's paper money is known as a fiat currency: its value is set and vouched for by a central bank. An independent entity, the central bank determines the amount of money in circulation at any given time.
Without a widely accepted currency, we would all have to barter for what we need. I give you a pair of shoes; you give me 10 pounds of flour. Complex industrialized economies would quickly collapse under such a primitive system. That's why central banks fear hyper-inflation, which destroys the value of paper currency. And why they will tolerate rising unemployment and lower output to nip inflation in the bud. Fortunately, these counter-measures generally succeed; inflation slows when money supplies tighten, allowing central banks to lower interest rates. An 'easy' monetary policy then replaces a 'tight' one, and the economy recovers.
A central bank institutes a tight monetary policy in several ways. Its option of first choice is to sell government bonds to banks. A bank pays for these securities with money it would have otherwise lent to businesses and consumer customers. When these open market operations prove insufficient, the central bank can raise the interest rate it charges for overnight loans it makes to banks, which tightens the banks' ability to issue credit to their customers. If all else fails, the central bank can raise the reserve requirement, which forces banks to hold more money in their vaults rather than lending it out, and thereby injecting it into the overall economy.
Tight money--especially if it results in deflation, or a general reduction in prices--increases the value of money already in circulation. Buyers get more bang for their buck. Lenders benefit because the value of the loan is higher when it is paid off then when it was borrowed. But there is less money to purchase goods with; economic output slows; joblessness climbs and those still working receive lower wages. Income shortfalls make it harder to service existing debt and virtually impossible to get additional loans.
Economies are huge, unwieldy, uncertain things. Monetary policy, at best, is a blunt instrument, a tight policy particularly so given the hardships that it tends to inflict on many. It's a 'bad' option in this sense. But the consequences of too much easy' money can be far worse. Central banks walk the tightrope between boom and bust indefinitely, incrementally adjusting interest rates up or down. But speculative asset- bubbles burst and fast growing economies overheat nonetheless. Then central bankers act more forcefully, striving to find an equilibrium between money that is too 'easy' and money that is too 'tight.'
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