Monetarism is the belief that the money supply is the most important factor in macroeconomic performance. Monetary policy alters the supply of money, which in turn affects interest rates. When the supply of money is low, the price of money—the interest rate—is high. When the supply of money is high, interest rates are low.

     The Fed can use monetary policy to expand or contract the U.S. economy. An easy money policy is a monetary policy that increases the money supply. A larger money supply means lower interest rates, which in turn means more money for investment and a boost to the economy. By contrast, a tight money policy is a monetary policy that reduces the money supply by raising interest rates, thus decreasing GDP.

     Timing is essential in monetary policy. Good timing smoothes out fluctuations in the business cycle. Bad timing can make the business cycle worse. For example, an expansionary policy may take effect as the economy is beginning to expand on its own, leading to overexpansion and inflation.

     An inside lag is a delay in implementing policy. It may occur because it takes time to recognize a problem. An outside lag is the time for a policy to take effect. Because of lags and the difficulty of predicting the direction of the economy, it is difficult to use monetary policy effectively. Some recessions are short and correct themselves in time. Policy makers are more likely to want to intervene in the case of a long and severe recession.