The Federal reserve enforces either the expansionary monetary policy or the contractionary monetary policy. In the expansionary one, the money supply is increased, and in the contractionary, the money supply is reduced. Now increasing and decreasing the money supply affects the interest rates, which are determined by the forces of demand and supply.
When the money supply increases and demand are constant, the interest rates decrease, and a new equilibrium is formed at lower interest rates from the initial equilibrium interest rates. On the other hand, if the money supply is reduced while demand is given, the interest rates increase, and a new equilibrium is formed above the equilibrium level. But this happens only in the short run.
The free-market forces are self-adjusting, thus in the long run, when interest rates fall due to increased money supply, it results in increased demand since interest rates and demand are inversely related. The increased demand for money will push the interest rates back to the equilibrium level, and consecutively the equilibrium level of interest rate is restored in the long run. The opposite will happen when interest rates are high than the equilibrium level. Thus, the monetary policy does not affect the long run since interest rates are restored to equilibrium.
The monetary policy affects the economy in the short-run and not in the long run since the interest rates deviate from the path of equilibrium in the short run. Still, since the interest rates depend upon the free market forces of demand and supply of money, which are self-adjusting, the equilibrium level of interest rates is restored in the long run, and monetary policy has no effect.
