Clark Johnson Explains How Monetary Policy Works

Clark Johnson wrote a really excellent book, Gold, France and the Great Depression, 1919-1932 on the international monetary disorders that produced the Great Depression, published by Yale University Press in 1997. The work stems from his doctoral dissertation at Columbia Yale University. Although Johnson wrote his dissertation in the history department (at Yale), Robert Mundell (from the economics department at Columbia) was involved in supervising the dissertation, and the final product is obviously the work of a gifted and insightful historian/economist. Additionally, Johnson gives ample recognition to the sadly neglected contributions of Gustav Cassel and R. G. Hawtrey, who more than anyone else at the time and almost anyone else since, diagnosed and understood the monetary pathology that produced the Great Depression.

In a newly published paper (in the Miliken Institute Review), Johnson compares the monetary disorders producing the current Little Depression to the monetary disorders that produced the Great Depression some 80 years ago. He organizes his paper around six widespread myths about monetary policy, explaining how reality is almost exactly the opposite of the myths now paralyzing the implementation of effective monetary policy.

Myth #1: The Federal Reserve has followed a highly expansionary monetary policy since August 2008.

Myth #2: Recovery from recessions triggered by financial crises is necessarily slow.

Myth #3: Monetary policy becomes ineffective when short-term interest rates fall to close to zero.

Myth #4: The greater the indebtedness incurred during growth years, the larger the subsequent need for debt reduction and the greater the downturn.

Myth #5: When monetary policy breaks down, there is a plausible case for a fiscal response.

Myth #6: The rising prices of food and other commodities are evidence of expansionary monetary policy and inflationary pressure.

One of Johnson’s most important points is to challenge the notion that the near-term objective of monetary ease ought to be to reduce interest rates. The objective of monetary policy in current circumstances must be to raise prices and to increase inflation expectations. Doing so will increase estimates of profitability and encourage investment, causing interest rates to rise not fall. Focusing on reducing interest rates simply feeds into the pessimistic expectations that are holding down spending (both investment and consumption) inasmuch as expectations of low interest rates into the future can be validated only by low levels of economic activity or falling prices, both of which are deterrents to current spending and inducements to holding cash. Whether Johnson is right in endorsing Ronald McKinnon’s suggestion that the leading central banks cooperate to increase short-term interest rates immediately is not so clear, but he is almost certainly right to argue that the FOMC’s promise to keep interest rates low for an extended period of time was, whatever its intent, deflationary in effect. I would also quibble with his suggestion that rising commodities prices are entirely independent of monetary policy, even though he is correct to observe that rapid economic growth by China and other developing countries is an independent, and perhaps more important, factor in fueling increases in commodities prices. (And let’s not forget ethanol subsidies and mandates, either.)

At any rate, kudos to Clark Johnson for this timely contribution. Let’s hope that Johnson will provide further valuable insights on economic and monetary policy.

Update 10/28:  I made a few changes in the first paragraph in response to Clark Johnson’s comment.


21 Responses to “Clark Johnson Explains How Monetary Policy Works”

  1. 1 Mitch October 24, 2011 at 9:07 pm

    You really think that this article has made anything like an argument on its “myth” number 5? In fact, what’s really odd is that his “myth” starts as “When monetary policy breaks down, there is a plausible case for a fiscal response”, but what his subheading says, in effect, is “Fiscal stimulus won’t work if it isn’t done right”. Well, duh.

    But it gets worse: (A) “Big government liberals” don’t want to expand the government for its own sake. That’s a straw man, and he “infers” it on no basis whatsoever. (B) It’s not at all clear that Krugman would agree that the stimulus had little effect because it wasn’t expected to last. Krugman states this over and over: the stimulus had some effect, but it was limited because the stimulus was far too small compared with the shortfall in aggregate demand. It’s not hard to know that Krugman says this, because he says it constantly. Where have you seen Krugman talk about expectations? Did Johnson even read Krugman before he decided to paraphrase him? (C) The whole section in the end is a total non-sequitur – in the end he simply asserts that the most important thing about fiscal stimulus is people’s expectations that it continue, but there’s no model, not even a real argument as to why that would be true.

    I find it perfectly plausible that in the absence of expectations that fiscal stimulus would be sustained, multipliers could be lower and stimulus could have reduced effects. That’s hardly a proof in its complete uselessness.


  2. 2 Gregor Bush October 25, 2011 at 7:43 am

    “Whether Johnson is right in endorsing Ronald McKinnon’s suggestion that the leading central banks cooperate to increase short-term interest rates immediately is not so clear”

    I think it’s pretty clear that this is wrong. McKinnon is making the same horrendous mistake that Kocherlakota made last year: ie. low interest rates are consistent with deflation therefore we should raise interest rates. If we woke up tomorrow to an announcement that the Fed, ECB and BoJ were all raising their policy rates – asset and commodity prices would plunge. Such a move would (correctly) be perceived as a tightening of monetary policy and would lead to expectations of weak AD. Interest rates at the long end would likely fall as markets would expect the move to eventually be reversed (see 1931).
    By contrast, if we woke up to an announcement that all three central banks pledged to do unlimited QE until their forecasts were on track to hit a level of nominal GDP that was higher than is currently projected, asset and commodity prices would soar. In this scenario, long-term interest rates would also rise as market would (correctly) expect central banks to exit their low interest rates policies sooner. But interest rates rising in response to an increase in expected future aggregate demand is not at all the same as central banks raising their policy rates.
    As Nic Rowe said, if the central bank credibly commits to a higher level of prices (or NGDP) the actual amount of QE/rate cuts that will need to be done is negative. That is, a commitment to a higher policy target will lead to a higher expected future path of the policy rate. But an announcement of a higher future path of the policy rate will lead to a lower expected path of the target variable (prices or NGDP).


  3. 3 David Pearson October 25, 2011 at 10:52 am

    I sometimes wonder if NGDP targeting proponents realize that China NGDP is growing at peak rates (around 16%) even while RGDP is slowing. Wouldn’t you expect China commodities prices to correlate more with China NGDP than RGDP? If so, this might explain why Brent Crude is still up 45% from Jackson Hole 2010 levels.

    Johnson argues that capital controls might be a solution to a China NGDP overshoot problem. In other words, China should stop hot money inflows to get NGDP growth under control. Perhaps, but capital flows are only part of the equation. Today, real deposit rates in China are around -3%. It is not surprising, then, that depositors look for alternative means of protecting purchasing power, including investing in commodities hoarding vehicles/schemes. This helps explain why the Chinese banking system is losing deposits fast.

    As for China inflation slowing, I would not hold my breath. Analysts tend to point to expected declines in commodities prices, but Chinese wages are now outpacing RGDP growth. Given the self-reinforcing dynamic of wage-price increases, China inflation may actually accelerate without further tightening.


  4. 4 Lars Christensen October 25, 2011 at 2:03 pm

    David, Clark’s paper is excellent. I truly hope he will continue to contribute to the debate about US and international monetary policy.


  5. 5 Benjamin Cole October 25, 2011 at 2:41 pm

    I liked the Clark paper. As for higher interest rates, I think he means that within the context of sustained QE and lower IOR. Also, Clark accepts at least some connection between US monetary policy and commodities speculation, as he says higher interest rates will quell some of that speculation. (My guess is rising real estate and stock prices will kill commodities. Why risk money on commodities when you can leverage 10-to-1 and buy real estate at bottom prices?).

    Nice review by David Glasner.


  6. 6 David Glasner October 25, 2011 at 9:06 pm

    Mitch, You are a tough critic. I read him as saying that unless fiscal stimulus is expected to be permanent, the marginal propensity to consume temporary increases in income is very low, so the multiplier will be very low. That seems fairly straightforward and uncontroversial.

    Gregor, I agree with you, not with Johnson and McKinnon. But the Fed should not be trying to ease by lengthening the time horizon of low rates.

    David, Sorry, but I am not on top of what is happening in China. If they are worried about inflation, they could allow the yuan to appreciate a bit faster. That would kill two birds with one stone. They shouldn’t let it appreciate so fast that they cause price to fall, but there doesn’t seem to be much danger of that.

    Lars, I liked it too, but Mitch does identify some sloppiness in his exposition.

    Benjamin, I am inclined to believe that Johnson favors an immediate increase in interest rates, but feels that there are other ways of easing to offset the increase in interest rates. I agree that a clear commitment to raise the price level would create upward pressure on interest rates.


  7. 7 Steve October 25, 2011 at 9:32 pm

    I view interest rate changes as multi-factor in cause and therefore it’s indeterminate whether the fed’s pledge is expansionary or contractionary.

    For example, the two-year zero rate pledge could be viewed as a promise to “passively ease” by keeping rates low even as the economy strengthens, or it could be viewed as a reduction in the targeted future NGDP path. The market is left to guess which it is.

    That’s why there is some truth to the argument that the Fed needs to augment its policy statements with more guidance as to the objectives.


  8. 8 John Hawkins October 25, 2011 at 9:46 pm

    There is something that’s been nagging at me lately about clamors for inflation to spur investment, and it’s that there is little talk about the effect of relative price changes on investment. By inflation, people seem to be talking about CPI. But what if, even though the CPI rises, PPI rises faster? If the PPI is rising faster than the CPI (if inflation in “higher order goods” is faster than “lower order goods”) wouldn’t that not be a boon to investment and actually hurt it? And it seems that the PPI is usually more responsive to monetary policy. Either my thinking is wrong or their is a huge gap in the policy debate about not just inflating prices, but inflating prices for final goods the faster than production goods.


  9. 9 Mitch October 26, 2011 at 9:40 am


    I am just tired of the denialism I see all over the place. You find whatever arguments you want to find and they always confirms whatever you believe to start with.

    Bear in mind that the “myth” is a quite sweeping statement that there is never a case for a fiscal response in a liquidity trap – in fact, the case isn’t even “plausible”. His argument proved nothing remotely close to that, and in fact marshaled no actual evidence that even the points he was trying to make were true. (To be clear: what I would consider evidence would be some numbers showing the sensitivity of the multipliers to expectations. And what does “permanent” mean? Is 2 years long enough? Ten? Just during the liquidity trap?)

    No denialism is complete without misrepresenting what people who disagree with you are saying, so he then he went on to (a) Mischaracterize what liberals believe (I.e. They don’t believe in expanding government for its own sake. For example, the desire to reduce the size of the defense budget is more prevalent on the liberal side of the political spectrum.) and (b) Misstate Krugman’s oft-repeated beliefs.

    As I said in my original post, I believe that multipliers are sensitive to expectations of fiscal and monetary policy. But it’s a very long distance from acknowledging that to believing in this “myth”.

    I don’t think I am being unduly harsh in my assessment. I am a layman with no particular axes to grind in any of these matters.

    (I originally started reading this blog because Krugman pointed to it one day, and I found the quality of argument engaging. Actually, I am surprised that you liked Johnson’s article, given how you write about other matters.)


  10. 10 Mitch October 26, 2011 at 9:41 am

    P.S. (“You” in the first paragraph should be read as “one”. I didn’t actually mean to refer to you, David.)


  11. 11 David Glasner October 26, 2011 at 7:50 pm

    Mitch, You have a point, but when I read his explanation of point 5, I interpreted his statement in light of the explanation. In other words, I interpreted him to mean that fiscal policy can be effective under certain conditions. So I can understand why you are annoyed, but I think that you are being too hard on Clark. Thanks, also for your clarification.

    Steve, I think you summed it up pretty well.

    John, Why do you assume that an increase in the PPI discourages investment?


  12. 12 John Hawkins October 26, 2011 at 10:02 pm

    The gut feeling is that if the new money chases producers goods faster than consumers goods, chasing them all the faster the higher up the “structure of production” they go, all the way up to physical assets and resources, then that would cut profits economy-wide (everything I make and sell is at a higher price, but the speed of increase of the costs of unit-production outpaces the speed of increase of the revenues per unit).

    Short example: I rent a oil rig usually at $2,000,000 but now it costs $3,000,000(+50%) because that’s what the money is chasing. The crude I dig up and sell is usually worth $3,500,000 but now market price is $4,000,000(+14%). The refinery can usually sell the oil & gas at $5,000,000 but now market price is $5,250,000(+5%). In this situation, everybody gets screwed except the rig owner. The rig owners profits rise +50%, the rig operator’s profits fall -33%, and the refiners profits fall -20%. Perhaps the rig owners will invest in more rigs, or more people will move to rig operation, (in MV=PQ terms, perhaps Q will rise) but the rig operation is only a small part of the final value added.

    What I’m saying is that “doves” have been arguing against “hawks” for so long that they seem to not be willing to take the advice they give and pay attention to problems that short-run neutrality of money might cause. Am I missing something in the theory itself (other than arguments over whether money is short-run neutral. “Money is either non-neutral or it is not money” – Mises)?

    Basically the thing I’m wondering is, if the price increases went in reverse of the way I gave in my example (roughly speaking CPI>PPI, as opposed to the example where PPI>CPI) then wouldn’t that cause an economy wide boom rather than a somewhat perverse sector specific boom?


  13. 13 John Hawkins October 26, 2011 at 10:33 pm

    I should clarify that by “sector specific” I believe I really mean “period of production specific”


  14. 14 Clark Johnson October 27, 2011 at 10:22 pm


    One detail — my PhD was from Yale, not Columbia. But I did work with Mundell, at least informallly.

    My comments on raising interest rates were rushed. I think coordinated action among the leading central banks would work better than alot of separate, “closed” economy efforts. A goal is certainly higher interest rates, but an even more immediate goal is to boot NGDP, and, to put it directly, to have a round of price increases — so to break the zero-interest trap. And this is where I would want to see joint action among central banks.

    Bernanke’s well-known paper on Japan (1999, I think) treats a zero-interest rate policy as expansionary. Similarly, the recent Goldman Sachs paper suggests that monetary policy works mainly through interest rates, hence proposes keeping ST interest rates near zero for years to come. I think both miss the point — a successful monetary policy will raise interest rates. These views are background for what I wrote, but I agree my explanation on raising rates was not complete.


  15. 15 David Glasner October 28, 2011 at 7:59 am

    John, Even if the price of crude rises faster than the price of gasoline, so that owners of crude gain relative to refiners and consumers, that encourages investment in drilling and exploration equipment, increasing incomes of people involved in those activities and so the expenditures and incomes circulate into other sectors. If resources are unemployed, the additional supply created by the newly employed factors of production will increase the demand for other products and services. Isn’t this just an example of how Say’s Law and the Keynesian multiplier are really two sides of the same coin?

    Clark, Thanks for your comment. I knew that you wrote your dissertation at Yale, but forgot. I just updated the post to reflect your comment. We agree totally that the goal of monetary ease is to raise interest rates not to lower them, though in the very short run, one might see real inflation-adjusted ex ante interest rates falling. But very quickly as price and profit expectations improve, real interest rates ought to increase as well.


  16. 16 OhMy October 28, 2011 at 10:30 am

    Clark Johnson’s article is rife with errors and conceptual misunderstandings.

    He claims that banks lend reserves. All this 2 years after MMT explained to half of the blogosphere 10x over that it is impossible (only banks have reserve accounts at the Fed, so cannot pay out reserves to a car dealership, say, or a household).

    Johnson continues to claim that paying interest on reserves is contractionary, while it was explained by Scott Fullwiller in detail, using banks balance shets and operational procedures to that it is actually slightly expansionary.

    There is confusion in Johnson’s article about fiscal policy and the “burden” of deficits (there is none, at least for a country that is the sole creator of the money it uses to spend, like the US, Japan, UK etc).

    Johnson is also deeply confused about cause and effect in the banking system – yes, the amount of reserves tracks the economic activity, as is known since the 1980s, simply because benks respond to increased loan volume by converting some of their assets to reserves, as required, but the mechanism never worked in the other direction: simply forcing banks into reserves does not create creditworthy borrowers and does not create demand for loans in a weakening economy.

    All of this was covered in countless discussions on the web and articles, and yet we have Clark Johnson rehashing all these falacies and being hailed as having written something worthwhile.


  17. 17 OhMy October 28, 2011 at 11:02 am

    As for Johnson’s “myths”, here is my take:

    Myth #1: The Federal Reserve has followed a highly expansionary monetary policy since August 2008.

    This “myth” is true, but there was not much they could do: they lowered the rates and prevented bank runs, good. The Fed cannot fix the economy by changing “expectations” because they have no tools to follow through. Just saying that they should “change expectations” is not enough. I cannot change expectations of the whole economy, because I have no tools to follow through, the same applies to the Fed. Never any mechanism was presented for the Fed to spur growth in presence of bad balance sheets, we only hear repeated arguments that “it can”. Nope.

    Myth #2: Recovery from recessions triggered by financial crises is necessarily slow.

    Indeed not true, fiscal policy can fix the balance sheets of the private sector very effectively and very fast.

    Myth #3: Monetary policy becomes ineffective when short-term interest rates fall to close to zero.

    Monetary policy is fairly ineffective no matter what the interest rates are. Even if effective, it should not be tried if the underlying problem is weak balance sheets: pushing more debt on the private sector is not the answer, the opposite is needed.

    Myth #4: The greater the indebtedness incurred during growth years, the larger the subsequent need for debt reduction and the greater the downturn.

    Point one is true (about the need for debt reduction), but the downturn needs not be great, if fiscal policy is aggressive enough.

    Myth #5: When monetary policy breaks down, there is a plausible case for a fiscal response.

    There is a plausible case for fiscal response long BEFORE monetary policy breaks down. Fiscal and monetary policies work differently, monetary policy eg. cannot fix balance sheets of the private sector, fiscal policy can. That is accounting 101.

    Myth #6: The rising prices of food and other commodities are evidence of expansionary monetary policy and inflationary pressure.

    Indeed not true, probably nobody claims this anyway. Commodities are exogenous factors.


  18. 18 David Glasner October 29, 2011 at 7:05 pm

    OhMy, First of all, I must plead relative ignorance about MMT, which I have seen discussed on some other blogs, but I have very little direct knowledge, even though I had some limited but quite pleasant interactions years ago with Warren Mossler when I was writing my book Free Banking and Monetary Reform. From the little I have seen, it strikes me that MMT have some interesting things to say, but are not very good at doing outreach to the uninitiated because of self-righteous shrillness with which they present their position. I mean, substance aside, they sound just like Austrians.

    On your specific points, I completely agree with you that it is not strictly correct to say that banks lend out their reserves. Maybe my emphasis on that point is why Mossler liked my book. However, I think Clark Johnson probably understands that, but expressed himself in the more conventional terminology of standard money and banking theory. I share your distaste for that theory (at least to some degree), but using the terminology is not necessarily proof of intellectual confusion.

    On paying interest on reserves, I agree with Johnson that doing so is contractionary and would welcome a reference to what Scott Fullwiller has to say on the subject. I am sorry, but the way you cite Scott Fullwiller seems to me exactly the way that Austrians cite Ludwig von Mises, so I was just wondering how you would compare Scott Fullwiller’s position in MMT to to that Ludwig von Mises in ABCT.

    On the burden of debt, I find that notion very tricky, because the burden of debt depends on what future income turns out to be. It also depends on who owns the debt. Did Germany’s indebtedness to the Allies after World War I have anything to do with the Great Depression?

    On reserves in the banking system, are you saying that the amount of reserves depends only on the demand for reserves by the banking system? If so, is that one-sided relationship a natural law or a consequence of a policy choice by the monetary authority?

    When you say Johnson’s myth #1 is true, do you mean that it truly is a myth or that it is not a myth? I take it that your position is that the Fed cannot have a monetary policy, which is an interesting position, but, and this may come as a shock to you, the weight of opinion on that question is still against you. That doesn’t mean that you are wrong, but I am not going to fault myself or Clark Johnson for taking a position upheld by most economists who ever lived, especially when that group includes Ralph Hawtrey and Earl Thompson.


  19. 19 Alan Reynolds June 16, 2016 at 8:20 am

    I have a typed copy of Clark Johnson’s July 1989 paper for Economics 589B (Workshop) “The French Gold Inflow, 1926-32” which I’d gladly send to him or David if I had an address.


  20. 20 David Glasner June 16, 2016 at 8:57 am

    Alan, Many thanks. Send it to me at the Bureau of Economics, FTC, Washington DC 20580. I have no contact information for Clark, but I think Scott Sumner is in touch with him.


  1. 1 Expectations Are Fundamental « Uneasy Money Trackback on October 31, 2011 at 6:57 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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