Do Real Balance Effects Invalidate the Taylor Principle in Closed and Open Economies

This paper examines the determinacy implications of forecast‐based monetary policy rules that set the interest rate in response to expected future inflation in a Neo‐Wicksellian model that incorporates real balance effects. We show that the presence of such effects in closed economies restricts the ability of the Taylor principle to prevent indeterminacy of the rational expectations equilibrium. The problem is exacerbated in open economies, particularly if the policy rule reacts to consumer‐price, rather than domestic‐price, inflation. However, determinacy can be restored in both closed and open economies with the addition of monetary policy inertia

Balance (ability) · Central bank · Determinacy · Economics · Exchange rate · Indeterminacy (philosophy) · Inflation (cosmology) · Interest rate · Keynesian economics · Macroeconomics · Monetary economics · Monetary policy · Open economy · Small open economy · Taylor rule · Economic theories and models · Economic Theory and Policy · Monetary Policy and Economic Impact

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